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Who Puts the Inflation Premium Into Nominal Interests Rates?

  • Benjamin M. Friedman
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    For expectations of price inflation to affect interest rates, they must affect the behavior of borrowers and lenders or both. This paper analyzes the emergence of the inflation premium in long-term interest rates as the explicit result of borrowers' and lenders' behavior in the bond market in response to price expectations. The object of this analysis is not only to estimate the magnitude of the inflation premium due to this portfolio behavior but also to evaluate the respective contributions to it of borrowers' and lenders' responses. The empirical results presented in this paper indicate that both borrowers' and lenders' portfolio behavior play an important role in the relationship between interest rates and inflation expectations. Estimation results for U.S. data provide evidence that, all other things equal, nonfinancial business corporations increase their supply (net issuance)of bonds in response to an increase in expected inflation; these results mirror the bond investors' responses found by the author in a previous paper. Partial equilibrium experiments based on the combined model of bond supply and bond demand indicate that, all other things equal, the port-folio responses to expected price inflation by borrowers and lenders together increase the bond yield by 2/3%, and modestly decrease the net quantity of bonds issued and purchased, in response to a 1% increase in expected inflation. This result follows as the consequence of a slightly greater response by lenders than by borrowers.

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    File URL: http://www.nber.org/papers/w0231.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0231.

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    Date of creation: Jan 1978
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    Publication status: published as Friedman, Benjamin M. "Who Puts the Inflation Premium into Nominal Interest Rates?" The Journal of Finance, Vol. XXXIII, No. 3, (June 1978), pp. 833-8 45.
    Handle: RePEc:nbr:nberwo:0231
    Note: ME
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    1. Sargent, Thomas J, 1971. "A Note on the 'Accelerationist' Controversy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 3(3), pages 721-25, August.
    2. Fama, Eugene F, 1970. "Multiperiod Consumption-Investment Decisions," American Economic Review, American Economic Association, vol. 60(1), pages 163-74, March.
    3. Benjamin M. Friedman & V. Vance Roley, 1977. "Identifying Identical Distributed Lag Structures by the Use of Prior SumConstraints," NBER Working Papers 0179, National Bureau of Economic Research, Inc.
    4. Ladenson, Mark L, 1971. "Pitfalls in Financial Model Building: Some Extensions," American Economic Review, American Economic Association, vol. 61(1), pages 179-86, March.
    5. Martin Feldstein, 1983. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 28-43 National Bureau of Economic Research, Inc.
    6. Modigliani, Franco & Shiller, Robert J, 1973. "Inflation, Rational Expectations and the Term Structure of Interest Rates," Economica, London School of Economics and Political Science, vol. 40(157), pages 12-43, February.
    7. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
    8. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
    9. Brundy, James M & Jorgenson, Dale W, 1971. "Efficient Estimation of Simultaneous Equations by Instrumental Variables," The Review of Economics and Statistics, MIT Press, vol. 53(3), pages 207-24, August.
    10. Friedman, Benjamin Morton, 1977. "Financial Flow Variables and the Short-Run Determination of Long-Term Interest Rates," Scholarly Articles 4554309, Harvard University Department of Economics.
    11. Smith, Gary, 1975. "Pitfalls in Financial Model Building: A Clarification," American Economic Review, American Economic Association, vol. 65(3), pages 510-16, June.
    12. Benjamin M. Friedman & V. Vance Roles, 1977. "Identifying Identical Distributed Lag Structures by the Use of Prior Sum Constraints," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 6, number 4, pages 429-444 National Bureau of Economic Research, Inc.
    13. McCallum, Bennett T, 1976. "Rational Expectations and the Natural Rate Hypothesis: Some Consistent Estimates," Econometrica, Econometric Society, vol. 44(1), pages 43-52, January.
    14. Friedman, Benjamin M, 1977. "Financial Flow Variables and the Short-Run Determination of Long-Term Interest Rates," Journal of Political Economy, University of Chicago Press, vol. 85(4), pages 661-89, August.
    15. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
    16. William C. Brainard & James Tobin, 1968. "Pitfalls in Financial Model-Building," Cowles Foundation Discussion Papers 244, Cowles Foundation for Research in Economics, Yale University.
    17. James M. Brundy & Dale W. Jorgenson, 1971. "Efficient estimation of simultaneous equations by instrumental variables," Working Papers in Applied Economic Theory 3, Federal Reserve Bank of San Francisco.
    18. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71, pages 280.
    19. Bodie, Zvi & Friedman, Benjamin Morton, 1978. "Interest Rate Uncertainty and the Value of Bond Call Protection," Scholarly Articles 4554310, Harvard University Department of Economics.
    20. Paul A. Samuelson, 1958. "An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money," Journal of Political Economy, University of Chicago Press, vol. 66, pages 467.
    21. Thomas J. Sargent, 1973. "Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 4(2), pages 429-480.
    22. Rutledge, John, 1977. "Irving Fisher and Autoregressive Expectations," American Economic Review, American Economic Association, vol. 67(1), pages 200-205, February.
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