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Optimal indexation of government bonds and monetary policy

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Abstract

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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  • Hatcher, Michael C., 2011. "Optimal indexation of government bonds and monetary policy," Cardiff Economics Working Papers E2011/3, Cardiff University, Cardiff Business School, Economics Section, revised Mar 2011.
    • Handle: RePEc:cdf:wpaper:2011/3
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    1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2007. "Optimal simple and implementable monetary and fiscal rules," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1702-1725, September.
    2. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
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    Cited by:

    1. Hatcher, Michael C., 2011. "Comparing inflation and price-level targeting: A comprehensive review of the literature," Cardiff Economics Working Papers E2011/22, Cardiff University, Cardiff Business School, Economics Section.

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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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