Why Investors Prefer Nominal Bonds: a Hypothesis

Abstract

The paper advances an answer to a puzzle: Why is any lending or borrowing done in terms of money, when such money debt exposes the lenders’ wealth to inflation risk? The ‘received’ answer to this question is that money bonds are just proxies for real bonds, proxies born of insufficient appreciation, or a benign neglect, of inflation risk. As mere ‘proxies’, this answer implies that money bonds are redundant: anything a money bond could do, a real bond could do. The thesis of the paper is that money bonds are not redundant. Money bonds have a social benefit. That benefit lies in the reduction that money bonds secure in the unpredictability of consumption that arises from the operation of real balance effects in an environment of unpredictable money shocks. It is the very vulnerability of money bonds to inflation makes them useful in immunising the economy against unpredictable redistributions of purchasing power caused by real balance effects.