Sunspots and Inflation-indexed Bonds

An economy with incomplete ?nancial markets, as described by Cass (1989), typically has in?ation volatility driven by sunspots. The purpose of this paper is to investigate how the introduction of in?ation- indexed bonds to the ?Cass?economy in?uences a monetary market, an indexed bond market, and welfare. The introduction of indexed bonds is considered a sunspot-stabilizing policy. However, this introduction unrealistically causes the complete shutdown of monetary markets. This problem can be avoided in this paper as incorporating proportional transaction costs in the indexed bond market. Specifically, I show that the monetary market can never shut down even with a very high level of in?ation volatility if the indexed bonds have transaction costs. In contrast, the indexed bond market can be inactive with a high value of transaction costs or low levels of in?ation volatility. This paper shows that the introduction of indexed bonds does not necessarily induce the economy to be Pareto improving. However, by allowing lump-sum tax-transfer plans that are implemented in period-0 money, the market with indexed bonds can be Pareto superior to the market without them. The conclusions derived from a single-good economy can be applied to a multi-good economy if all agents have an identical homothetic utility function.