On indexed bonds and aggregate demand elasticity.

Introduction

Inflation indexed government bonds, which were first issued by the Commonwealth of Massachusetts during the Revolutionary War, (1) have become rather popular and widely used in the industrialized world. Indeed, the United States joined 14 other countries (2) in 1997 when it began offering this particular type of asset. The US Federal government currently sells two types of inflation indexed instruments: Treasury Inflation Protection Securities, or TIPS, and Series I savings bonds.

The benefits and implications of indexed bonds are well-known and some of these have become incorporated into modern macroeconomics textbooks. For example, Mankiw states that these bonds will result in "less inflation risk, more financial innovation, better government incentives, more informed monetary policy, and easier lives for students and teachers of macroeconomics." (3) Gordon, on the other hand, emphasizes only that a bond indexed to inflation "protects savers from unexpected movements in the inflation rate." (4) Additionally, and earlier in the literature, both Jevons (5) and Marshall (6) believed that bond indexation would decrease the variability of the business cycle. Fisher (7), and later Friedman (8), thought that indexed bonds would contribute to increased price stability. Finally, Keynes (9) proposed that a government could reduce its borrowing costs with the use of these assets.

We believe that indexed bonds present yet another and to our knowledge unidentified implication for macroeconomics. In general, our hypothesis is that the existence of these assets will impact the price level elasticity of aggregate demand. (10) More specifically, our theory is that inflation indexed bonds, as a component of wealth and via the Pigou effect, cause aggregate demand to become more inelastic with respect to the general price level. The purpose of this paper, therefore, is to explore the relationship between indexed bonds and aggregate demand elasticity.

The paper proceeds as follows. The next section presents a model of aggregate demand which includes indexed bonds as a part of real wealth and derives an expression for aggregate demand elasticity from which we can assess our basic contention. This section also discusses briefly some implications of our findings. The final section concludes by providing a brief summary of the paper.

The Model

The model of aggregate demand developed here is an otherwise standard IS-LM framework augmented by the inclusion of both indexed and non-indexed bonds as components of total real wealth. The product market consists of real saving (s) that depends on real income (y) and real value of financial assets (A/p). Nominal financial assets (A) equal the sum of narrow money balances (M) and bonds, with the bond component being disaggregated into bonds indexed to changes in the general price level, [B.sup.I](p), and those bonds that are not indexed ([B.sup.N]). Aggregate real investment (i) is determined by the market rate of interest (r). The product market equilibrium condition can now be specified as: