Indexed versus nominal government debt under inflation and price-level targeting

Abstract

This paper presents a DSGE model in which long run inflation risk matters for social welfare. Optimal indexation of long-term government debt is studied under two monetary policy regimes: inflation targeting (IT) and price-level targeting (PT). Under IT, full indexation is optimal because long run inflation risk is substantial due to base-level drift, making indexed bonds a better store of value than nominal bonds. Under PT, where long run inflation risk is largely eliminated, optimal indexation is substantially lower because nominal bonds become a relatively better store of value. These results are robust to the PT target horizon, imperfect credibility of PT and model calibration, but the assumption that indexation is lagged is crucial. A key finding from a policy perspective is that indexation has implications for welfare comparisons of IT and PT.