Price Inflation, Portfolio Choice, and Nominal Interest Rates

Abstract

Among the different kinds of economic behavior which may account for the familiar Fisherian relationship between nominal interest rates and expected price inflation, portfolio behavior is the most plausibly flexible in the short run.Since substitution into real assets is not a practical portfolio alternative for many investors, however, it is not obvious a priori how important lenders' portfolio behavior can be in bringing about the adjust- ment of interest rates which Fisher's theory associates with expected infla- tion.Given the importance of this adjustment for questions of both monetary theory and monetary policy, the underlying economic behavior merits explicit investigation.The empirical results presented in this paper provide evidence that lenders' portfolio behavior does play an important role in the expected-priceinflation/nomjnal-jnterest..rate relationship.First, results indicate that five of the six major categories of investors in the U.S. long-term bond market reduce their demands for bonds in response to an increase in expected inflation.Secondly, the results of multi-equation partial-equilibri experiments indicate that ,with all other things unchanged, this response by investors will raise the equilibrium nominal bond yield by about 2/3% in response to a 1% increase in expected inflation.

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