The Market for Indexed Financial Instruments

The lack of indexed financial instruments has long puzzled economists because their benefits seem obvious. Using a two-period model with random inflation, the author shows that borrowers and lenders prefer indexed instruments when their incomes are adjusted for inflation. Without adjustment, however, borrowers prefer nominal instruments. When adjustment is uncertain, real interest rates on indexed instruments resemble expected real interest rates on nominal instruments and neither instrument dominates. Given the cost of financial innovation, it is not surprising that indexed instruments have not arisen.