Inflation-linked bonds in incomplete markets with sunspots

Abstract

AbstractThis paper investigates the impact of the introduction of inflation-linked bonds, which incur transaction costs when traded, on the monetary economy with sunspots. This paper shows that there always exists a certain range of positive transaction costs, where both monetary and bond markets are active. This implies that on top of governments, profit-seeking financial entrepreneurs also have the incentive to issue these bonds. This paper also displays how financial innovation on the indexed bond can be Kaldor improving, even if not necessarily Pareto improving. This finding indicates that together with lump-sum tax policies, the government can attain consensus among consumers on bond issuance.