Abstract

The market demand for the Treasury Inflation-Protected Securities (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.
Original languageEnglish
Pages (from-to)171-214
Number of pages44
JournalJOURNAL OF MONEY, CREDIT, AND BANKING
Volume55
DOIs
Publication statusPublished - 2023

Keywords

  • TIPS
  • money illusion
  • portfolio choice
  • term structure of interest rates

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