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Sunspots and Inflation-indexed Bonds

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  • Minwook KANG

    (Division of Economics, School of Humanities and Social Sciences, Nanyang Technological University, Singapore, 637332.)

Abstract

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.

Suggested Citation

  • Minwook KANG, 2014. "Sunspots and Inflation-indexed Bonds," Economic Growth Centre Working Paper Series 1401, Nanyang Technological University, School of Social Sciences, Economic Growth Centre.
  • Handle: RePEc:nan:wpaper:1401
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    File URL: http://www3.ntu.edu.sg/hss2/egc/wp/2014/2014-01.pdf
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    References listed on IDEAS

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    1. Balasko, Yves, 1983. "Extrinsic uncertainty revisited," Journal of Economic Theory, Elsevier, vol. 31(2), pages 203-210, December.
    2. Bhattacharya, Joydeep & Guzman, Mark G. & Shell, Karl, 1998. "Price Level Volatility: A Simple Model of Money Taxes and Sunspots," Journal of Economic Theory, Elsevier, vol. 81(2), pages 401-430, August.
    3. Gaetano Antinolfi & Todd Keister, 1998. "Options and sunspots in a simple monetary economy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 11(2), pages 295-315.
    4. Michael Magill & Martine Quinzii, 1997. "Which improves welfare more: A nominal or an indexed bond?," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 10(1), pages 1-37.
    5. Cass, David & Shell, Karl, 1983. "Do Sunspots Matter?," Journal of Political Economy, University of Chicago Press, vol. 91(2), pages 193-227, April.
    6. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
    7. Goenka, Aditya & Prechac, Christophe, 2006. "Stabilizing sunspots," Journal of Mathematical Economics, Elsevier, vol. 42(4-5), pages 544-555, August.
    8. Atsushi Kajii, 1997. "On the Role of Options in Sunspot Equilibria," Econometrica, Econometric Society, vol. 65(4), pages 977-986, July.
    9. Foley, Duncan K., 1970. "Economic equilibrium with costly marketing," Journal of Economic Theory, Elsevier, vol. 2(3), pages 276-291, September.
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    More about this item

    Keywords

    In?ation-indexed bonds; Sunspots; In?ation volatility; Transaction costs; Consumer price index (CPI);

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