Money Illusion and TIPS Demand

137 Pages Posted: 7 May 2018 Last revised: 1 Feb 2022

See all articles by Abraham Lioui

Abraham Lioui

EDHEC Business School

Andrea Tarelli

Catholic University of Milan

Date Written: March 22, 2019

Abstract

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

Lioui, Abraham and Tarelli, Andrea, Money Illusion and TIPS Demand (March 22, 2019). Available at SSRN: https://ssrn.com/abstract=3166909 or http://dx.doi.org/10.2139/ssrn.3166909

Abraham Lioui

EDHEC Business School ( email )

France

Andrea Tarelli (Contact Author)

Catholic University of Milan ( email )

Largo Gemelli, 1
Milan, 20123
Italy

HOME PAGE: http://sites.google.com/view/andreatarelli

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