Journal of Monetary Economics 15 (1985) 291-308. North-Holland STOCHASTIC INFLATION AND GOVERNMENT PROVISION OF INDEXED BONDS Dan PELED* GSIA, Carnegie-Mellon University. Pittsburgh, PA 15213, USA Technion - Israel Institute of Technolop, Haifa, Israel This paper examines the consequences of using indexed bonds as one of the government financing instruments, along with money and taxes. It is shown that open market operations between money and indexed bonds do not matter in a real sense despite their different risk characteristics. Increasing the share of indexed bonds in the government portfolio increases the volatility and the conditional mean of real rates of return on money. When provided by means other than open market operations, indexed bonds can affect the allocation of resources, but these reallocations cannot be Pareto-improving. 1. Introduction Indexed bonds can be viewed as titles to a given amount of purchasing power at a specified future point in time. The purchasing power is guaranteed by linking nominal interest and principal payoffs to some index of prices, typically the CPI. Several countries (Brazil, Finland, France, Israel, and most recently, England) have used government issued indexed bonds to finance part of their governments’ expenditures. The success of these experiences has varied across these countries, and has lead to their abandonment in some of them. The use of indexed bonds is notably absent in the developed financial’markets of the U.S. although repeated suggestions in that direction have recently reappeared in the popular press.’ The provision of index-linked bonds has for long been advocated by some economists such as Tobin (1971, 1972) and Friedman (1974). Various argu- ments are offered in favor of issuing this kind of government liability: expanded opportunity set for investors; lower real interest costs on a given real government debt; improved government control over the real interest rate; providing investors with an alternative to the wasteful hording of capital as a hedge against inflation; and a potential restraint against government tendency *Neil Wallace’s advice was instrumental for this research. I have also benefited from construc- tive comments by Zvi Pckstein, Martin Eichenbaum, Stephen LeRoy, Bennett McCall~, AlIan Melher, Charles Plosser and an anonymous referee. Shortcomings, however, are my own. This research was supported by NSF grant SES8107253. ‘Newsweek, October 14, 1981; Burinessweek, April 19, 1982. 0304-3923/85/$3.3001985, Elsevier Science Publishers B.V. (North-Holland)