Inflation-Linked Bonds, Nominal Bonds, and Countercyclical Monetary Policies

Although inflation-linked bonds have many advantages, nominal bonds are
the most important instrument to finance public debts throughout the world.
One explanation that the literature has offered is that nominal bonds make
countercyclical monetary policies more effective. This paper reconsiders this
argument with a model that features an inflation risk premium in the nominal
bonds interest rate. In this model, nominal bonds help to stabilize the
economy, but also add to debt service costs. The paper finds that the debt
service 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.