Money Illusion and TIPS Demand
137 Pages Posted: 7 May 2018 Last revised: 1 Feb 2022
Date Written: March 22, 2019
The market demand for TIPS is rather small. This is puzzling, as we show that an agent, who derives utility from real wealth and dynamically invests into multiple asset classes over a 30-year horizon, incurs a certainty equivalent loss of 1.6% per annum from not investing in inflation-indexed bonds. However, if the investor suffers from money illusion, the perceived loss is only 0.5% per annum. Furthermore, the perceived loss is totally negligible for an unsophisticated money-illusioned investor ignoring the time variation of risk premia. Money illusion causes significant portfolio shifts from inflation-indexed toward nominal bonds, with little effects on equity allocations, contributing to the low market demand for TIPS.
Keywords: Money Illusion, Term Structure of Interest Rates, TIPS, Portfolio Choice
JEL Classification: E43, E52, G11, G12
Suggested Citation: Suggested Citation