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Optimal indexation of government bonds and monetary policy

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    Using an overlapping generations model in which the young save for old age using indexed and nominal government bonds, this paper investigates how optimal indexation is influenced by monetary policy. In order to do so, two monetary policies with markedly different long run implications are examined: inflation targeting and price-level targeting. Optimal indexation differs significantly under the two regimes. Under inflation targeting, long-term inflation uncertainty is substantial due to base-level drift in the price level. Nominal bonds are thus a poor store of value and optimal indexation is relatively high (76 per cent). With price-level targeting, by contrast, long-term inflation uncertainty is minimal because the price level is trend-stationary. This makes nominal bonds a better store of value compared to indexed bonds, reducing optimal indexation somewhat (26 per cent). Importantly for these results, the model captures two imperfections of indexation (indexation bias and lagged indexation) that are calibrated to the UK case.

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    Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2011/3.

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    Length: 46 pages
    Date of creation: Jan 2011
    Date of revision: Mar 2011
    Handle: RePEc:cdf:wpaper:2011/3
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