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Quantitative implications of indexed bonds in small open economies

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  • Ceyhun Bora Durdu

Abstract

This paper analyzes the macroeconomic implications of real-indexed bonds, indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the benefits that these bonds introduce. When the nonindexed bond market is shut down and only indexed bonds are available, indexation strengthens the precautionary savings motive, increases consumption volatility and deepens the impact of Sudden Stops for degrees of indexation higher than a certain threshold. When the nonindexed bond market is retained, nonmonotonic relationship between the degree of indexation and the benefits of indexed bonds still remain. Degrees of indexation higher than a certain threshold lead to more volatile consumption than lower degrees of indexation. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 909.

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Date of creation: 2007
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Handle: RePEc:fip:fedgif:909

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Keywords: Inflation-indexed bonds ; Bond market;

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Citations

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Cited by:
  1. Juan Carlos Hatchondo & Cesar Sosa-Padilla & Leonardo Martinez, 2010. "Debt dilution, overborrowing, and sovereign default risk," 2010 Meeting Papers 481, Society for Economic Dynamics.
  2. Marco E. Terrones & Enrique G. Mendoza & Ceyhun Bora Durdu, 2008. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism," 2008 Meeting Papers 56, Society for Economic Dynamics.
  3. Durdu, Ceyhun Bora, 2009. "Quantitative implications of indexed bonds in small open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 33(4), pages 883-902, April.
  4. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "Debt dilution and sovereign default risk," Working Paper 10-08, Federal Reserve Bank of Richmond.
  5. Javier Bianchi, 2009. "Overborrowing and systemic externalities in the business cycle," Working Paper 2009-24, Federal Reserve Bank of Atlanta.
  6. Ceyhun Bora Durdu & Serdar Sayan, 2008. "Emerging market business cycles with remittance fluctuations," International Finance Discussion Papers 946, Board of Governors of the Federal Reserve System (U.S.).
  7. repec:fip:fedreq:y:2012:i:2q:p:139-157:n:vol.98no.2 is not listed on IDEAS
  8. C. Bora Durdu, 2011. "Review of "Emerging Markets Resilience and Growth Amid Global Turmoil by M. Ayhan Kose and Eswar S. Prasad"," Koç University-TUSIAD Economic Research Forum Working Papers 1111, Koc University-TUSIAD Economic Research Forum.
  9. Juan Carlos Hatchondo & Francisco Roch & Leonardo Martinez, 2012. "Fiscal Rules and the Sovereign Default Premium," IMF Working Papers 12/30, International Monetary Fund.
  10. Gondo, Rocío, 2014. "State Contingent Assets, Financial Crises and Pecuniary Externalities in Models with Collateral Constraints," Working Papers 2014-001, Banco Central de Reserva del Perú.

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