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Although inflation-linked bonds have many advantages, nominal bonds arethe most important instrument to finance public debts throughout the world.One explanation that the literature has offered is that nominal bonds makecountercyclical monetary policies more effective. This paper reconsiders thisargument with a model that features an inflation risk premium in the nominalbonds interest rate. In this model, nominal bonds help to stabilize theeconomy, but also add to debt service costs. The paper finds that the debtservice costs channel is very powerful: in the case of discretionary policymaking,inflation-linked bonds always outperform nominal bonds. The case of commitment qualifies this result. Still, also commitment cannot explain the occurrence of large stocks of nominal bonds alongside small stocks of inflation-linked bonds. |
