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A Portfolio-Balance Model of Inflation and Yield Curve Determination

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  • Antonio Diez de los Rios
Abstract
We propose a portfolio-balance model of the yield curve in which inflation is determined through an interest rate rule that satisfies the Taylor principle. Because arbitrageurs care about their real wealth, they only absorb an increase in the supply of nominal bonds if they are compensated with an increase in their real rates of return. At the same time, because the Taylor principle implies that short-term nominal rates are adjusted more than one for one in response to changes in inflation, the real return on nominal bonds depends positively on inflation. In equilibrium, inflation increases when there is an increase in the supply of nominal bonds to compensate arbitrageurs for the additional supply they have to hold.

Suggested Citation

  • Antonio Diez de los Rios, 2020. "A Portfolio-Balance Model of Inflation and Yield Curve Determination," Staff Working Papers 20-6, Bank of Canada.
    • Handle: RePEc:bca:bocawp:20-6
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    References listed on IDEAS

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    Cited by:

    1. Andras Lengyel, 2022. "Treasury Supply Shocks and the Term Structure of Interest Rates in the UK," MNB Working Papers 2022/6, Magyar Nemzeti Bank (Central Bank of Hungary).

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    More about this item

    Keywords

    Asset Pricing; Debt Management; Inflation and prices; Interest rates; Monetary Policy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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