November 15, 2006
C. Bora Durdu
Recent studies have proposed setting up a benchmark market for indexed bonds to prevent "Sudden Stops," emerging-market crises initiated by sudden reversals of capital inflows. This paper analyzes the macroeconomic implications of such bonds, which would be indexed to the terms of trade or GDP, using a general equilibrium model of a small open economy with financial frictions. Although indexed bonds provide a hedge to income fluctuations and can thereby mitigate the effects of financial frictions, they introduce interest rate fluctuations. Because of this tradeoff, there exists a nonmonotonic relation between the "degree of indexation" (i.e., the percentage of the shock reflected in the return) and the effects of these bonds on macroeconomic fluctuations. Therefore, indexation can improve macroeconomic conditions only if the degree of indexation is less than a critical value. When the degree of indexation is higher than this threshold, it strengthens the precautionary savings motive and increases consumption volatility and the impact effect of Sudden Stops. The threshold degree of indexation depends on the volatility and persistence of income shocks as well as on the relative openness of the economy.