Markets for Inflation Indexed Securities as Mechanisms for Efficient Monetary Policy

Posted: 1 Apr 2009 Last revised: 18 Oct 2012

See all articles by Christian-Oliver Ewald

Christian-Oliver Ewald

University of Glasgow; Center for Dynamic Macroeconomic Analysis, University of St. Andrews - School of Economics and Finance

Johannes Geissler

University of St Andrews - School of Economics and Finance

Date Written: October 17, 2012

Abstract

We consider a continuous time framework featuring a central bank, private agents and a financial market. The central bank’s objective is to maximize a functional, which measures the classical trade-off between output and inflation over time plus income from the sales of inflation indexed bonds minus payments for the liabilities that the inflation indexed bonds produce at maturity. Private agents are assumed to have adaptive expectations. The financial market is modeled in continuous time Black-Scholes-Merton style and financial agents are averse against inflation risk, attaching an inflation risk premium to nominal bonds. Following this route, we explain demand for inflation indexed securities on the financial market from a no-arbitrage assumption and derive pricing formulas for inflation linked bonds and calls, which lead to a supply-demand equilibrium. Furthermore, we study the consequences that the sales of inflation indexed securities have on the observed inflation rate and price level. Similar as in Walsh (1995) we find that the inflationary bias is significantly reduced, and hence that markets for inflation indexed bonds provide a mechanism to reduce inflationary bias and increase central bank’s credibility.

Keywords: Monetary policy, inflationary bias, mechanisms, inflation indexed

JEL Classification: E52, E61, C73, E44

Suggested Citation

Ewald, Christian-Oliver and Geissler, Johannes, Markets for Inflation Indexed Securities as Mechanisms for Efficient Monetary Policy (October 17, 2012). Available at SSRN: https://ssrn.com/abstract=1371460 or http://dx.doi.org/10.2139/ssrn.1371460

Christian-Oliver Ewald

University of Glasgow ( email )

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

Center for Dynamic Macroeconomic Analysis, University of St. Andrews - School of Economics and Finance ( email )

Castlecliffe
The Scores
St. Andrews, Fife KY16 9AL
United Kingdom
+44(0)1334 462435 (Phone)

HOME PAGE: http://www.maths.usyd.edu.au/u/ewald/

Johannes Geissler (Contact Author)

University of St Andrews - School of Economics and Finance ( email )

The Scores, Castlecliff
St. Andrews, Fife KY16 8RD
United Kingdom

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