The Federal Reserve Board eagle logo links to Board's home page

International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Quantitative Implications of Indexed Bonds in Small Open Economies
Ceyhun Bora Durdu
2007-909  (November 2007)

Abstract:  This paper analyzes the macroeconomic implications of real-indexed bonds, indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the benefits that these bonds introduce. When the nonindexed bond market is shut down and only indexed bonds are available, indexation strengthens the precautionary savings motive, increases consumption volatility and deepens the impact of Sudden Stops for degrees of indexation higher than a certain threshold. When the nonindexed bond market is retained, nonmonotonic relationship between the degree of indexation and the benefits of indexed bonds still remain. Degrees of indexation higher than a certain threshold lead to more volatile consumption than lower degrees of indexation. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.

Full paper(673 KB PDF) | Full paper (screen reader version)

Indexed bonds, degree of indexation, financial frictions, sudden stops

PDF files: Adobe Acrobat Reader   ZIP files: PKWARE

Home | IFDPs | List of 2007 IFDPs
Accessibility | Contact Us
Last update: November 28, 2007