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A Portfolio-Balance Model of Inflation and Yield Curve Determination

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How does the supply of nominal government debt affect the macroeconomy? One answer is found in modern versions of the preferred-habitat and portfolio-balance theories of the yield curve. Everything else the same, a decrease in the supply of nominal bonds should increase their price. This lowers market interest rates and thus supports economic growth and staves off deflationary pressures. Central bank officials often cite this mechanism to justify using large-scale asset purchases (also known as quantitative easing) in an unconventional monetary policy toolkit.

In this paper, I depart from assumptions in preferred-habitat and portfolio-balance theories of the yield curve in two ways:

  1. I assume investors are risk-averse and care about their future real wealth. Investors would rather hold real bonds (which are safe) than nominal bonds (which are subject to inflation risk). Therefore, they will only hold long-term nominal bonds if they are sufficiently compensated (i.e., by an increase in the real rates of return of nominal bonds).
  2. I assume the Taylor principle in central bank behavior: that is, short-term nominal interest rates are adjusted more than one-for-one in response to any change in inflation. The return to investing in nominal vis-à-vis real bonds thus increases when inflation increases because the central bank raises interest rates more than inflation. This leads to real gains from investing in nominal bonds.

My model predicts that a decrease in the supply of nominal bonds can lead to lower inflation. The model is not realistic enough to fully describe the dynamics of inflation. However, results indicate the potential for portfolio-balance effects of quantitative easing that are contrary to the common wisdom of policymakers.