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March 2018 issue
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Mehrotra
Tölö, Laakkonen, Kalatie
Chiu, Hill
Belongia, Ireland
Fornero, Kirchner
Rose, Spiegel
Abbritti, Dell’Erba, Moreno, Sola
Ihrig, Klee, Li, Wei, Kachovec
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Bond Vigilantes and Inflation

by Andrew K. Rosea and Mark M. Spiegelb

Abstract

This paper explores the relationship between inflation and the existence of a local, nominal, publicly traded, longmaturity, domestic currency bond market. Domestic bond markets have an unclear effect on inflation; they present issuing governments with the opportunity to inflate away their debt obligations, but they also expose bondholders to capital losses through inflation, creating a potential anti-inflationary force. We ask whether the latter effect is apparent empirically. We use a panel of data, examining inflation before and after the introduction of a domestic bond market. Inflationtargeting countries with a bond market experience inflation at least 3 to 4 percentage points lower than those without one. This effect is economically and statistically significant; it is also insensitive to a variety of estimation strategies. In particular, we use a wide variety of political and fiscal instrumental variables to account for the potential endogeneity of domestic bond issuance. Moreover, we do not find a similar effect for indexed or foreign currency bonds.

JEL Code: E52, E58.

 
Full article (PDF, 37 pages, 544 kb)


a Haas School of Business
b Federal Reserve Bank of San Francisco