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Indexed Bonds and Monetary Policy: The Real Interest Rate and the Expected Rate of Inflation

  • Kitamura, Yukinobu

    (Keio U and Bank of Japan)

This paper presents a method for deriving the real interest rate and the expected rate of inflation from the market information contained in indexed government bonds. It also discusses the implications and potential use for monetary policy of the information derived about the real interest rate and the expected rate of inflation. In theory, the real interest rate represents the marginal product of capital or the discount rate used in intertemporal market exchanges. Therefore, it acts to signal conditions in the real economy. The expected rate of inflation represents the average expectation of market participants about future inflation. Therefore, it affects the economic decisions of market participants. It contains information about the judgment of market players, which is useful as a leading indicator of the future price level. This paper uses data on U.K. government-indexed bonds. It shows that the derived real interest rate and the expected rate of inflation provide very useful information for monetary policy. This paper also shows that the Fisher equation and the rational expectations hypothesis are incompatible, and that the expected rate of inflation obtained from the Fisher equation is far more stable than the realized rate of inflation and the expected rate of inflation obtained from the rational expectations hypothesis.

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File URL: http://www.imes.boj.or.jp/research/papers/english/me15-1-1.pdf
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Article provided by Institute for Monetary and Economic Studies, Bank of Japan in its journal Monetary and Economic Studies.

Volume (Year): 15 (1997)
Issue (Month): 1 (May)
Pages: 1-25

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Handle: RePEc:ime:imemes:v:15:y:1997:i:1:p:1-25
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  1. Lars E.O. Svensson, 1994. "Estimating and Interpreting Forward Interest Rates: Sweden 1992 - 1994," NBER Working Papers 4871, National Bureau of Economic Research, Inc.
  2. Frederic S. Mishkin, 1981. "The Real Interest Rate: An Empirical Investigation," NBER Working Papers 0622, National Bureau of Economic Research, Inc.
  3. Nelson, Charles R & Siegel, Andrew F, 1987. "Parsimonious Modeling of Yield Curves," The Journal of Business, University of Chicago Press, vol. 60(4), pages 473-89, October.
  4. Mishkin, Frederic S., 1990. "What does the term structure tell us about future inflation?," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 77-95, January.
  5. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71, pages 280.
  6. McCulloch, J Huston, 1975. "The Tax-Adjusted Yield Curve," Journal of Finance, American Finance Association, vol. 30(3), pages 811-30, June.
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