Money Illusion and TIPS Demand
116 Pages Posted: 7 May 2018 Last revised: 27 Mar 2019
Date Written: March 22, 2019
The market demand for TIPS is rather small. This seems surprising, as we show that a rational agent, dynamically investing into multiple asset classes over a 30-year horizon, benefits by a 1.7% certainty equivalent gain per annum from having access to inflation-indexed bonds. However, if the investor suffers from money illusion, the perceived gain reduces to 0.6%. Furthermore, the ex-ante subjective benefits become totally negligible if the money-illusioned investor is less sophisticated and ignores time variations in risk premia. Money illusion causes significant portfolio shifts from inflation-indexed toward nominal bonds, with little effects on equity allocations. The UK-based evidence confirms the baseline findings obtained from U.S. data.
Keywords: Money Illusion, Term Structure of Interest Rates, Portfolio Choice
JEL Classification: E43, E52, G11, G12
Suggested Citation: Suggested Citation