Quantitative Implications of Indexed Bonds in Small Open Economies

49 Pages Posted: 9 Dec 2007

See all articles by Ceyhun Bora Durdu

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System

Date Written: October 2007

Abstract

This paper analyzes the macroeconomic implications of real-indexed bonds, indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the degree of indexation (i.e., the percentage of the shock reflected in the return) and the benefits that these bonds introduce. When the nonindexed bond market is shut down and only indexed bonds are available, indexation strengthens the precautionary savings motive, increases consumption volatility and deepens the impact of Sudden Stops for degrees of indexation higher than a certain threshold. When the nonindexed bond market is retained, nonmonotonic relationship between the degree of indexation and the benefits of indexed bonds still remain. Degrees of indexation higher than a certain threshold lead to more volatile consumption than lower degrees of indexation. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.

Keywords: indexed bonds, degree of indexation, financial frictions, sudden stops

JEL Classification: F41, F32, E44

Suggested Citation

Durdu, Ceyhun Bora, Quantitative Implications of Indexed Bonds in Small Open Economies (October 2007). FRB International Finance Discussion Paper No. 909, Available at SSRN: https://ssrn.com/abstract=1066787 or http://dx.doi.org/10.2139/ssrn.1066787

Ceyhun Bora Durdu (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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