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5 - Implications of inflation uncertainty and differential inflationary expectations for the bond market and its allocative efficiency

Published online by Cambridge University Press:  07 October 2011

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Summary

Introduction

Discussions of bond market equilibrium in an inflationary environment traditionally rely on a version of Fisher's (1896) theory of interest, in which the inflationary expectation, whether correct or not, is the same for all participants in the bond market at a given time. As a consequence, given the equilibrium nominal rate of interest, there is only one real rate of interest, which is equal to the nominal rate minus the uniformly expected rate of inflation. As should be clear from Chapter 4, however, inflationary expectations are far from uniform, and their cross-sectional distribution tends to vary over time. This chapter develops the implications of varying degrees of inflation uncertainty and a divergence of views about future inflation for the bond market.

Chapter 4 showed how monetary uncertainty affects inflationary expectations. This chapter will investigate the effects of inflation uncertainty and differential inflationary expectations on the allocative efficiency of the bond market, the volume of trade in bonds, the size of windfall gains and losses, and Fisher's theory of interest.

The implications of differential expectations for the equilibrium of the bond market are presented in Section 2. A generalization of Fisher's theory of interest for the case of heterogeneous expectations appears in Section 3. Section 4 investigates how inflation uncertainty and the variability of inflationary expectations over time and individuals affect the allocative efficiency of the bond market. Section 5 focuses on the relationship between the nonuniformity of expectations and the volume of trade in the bond market.

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Publisher: Cambridge University Press
Print publication year: 1984

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