Ambiguity Aversion and the absence of indexed debt.

Book section

Following the seminal works of Schmeidler (1989), Gilboa and Schmeidler (1989), roughly put, an agentrsquos subjective beliefs are said to be ambiguous if the beliefs may not be represented by a unique probability distribution, in the standard Bayesian fashion, but instead by a set of probabilities. An ambiguity averse decision maker evaluates an act by the minimum expected value that may be associated with it. In spite of wide and long-standing support among economists for indexation of loan contracts there has been relatively little use of indexation, except in situations of extremely high inflation. The object of this paper is to provide a (theoretical) explanation for this puzzling phenomenon based on the hypothesis that economic agents are ambiguity averse. The paper considers a general equilibrium model based on Magill and Quinzii (1997) with ambiguity averse agents, where both nominal and indexed bond contracts are available for trade and all relevant prices are determined endogenously. We obtain conditions which prompt an endogenous cessation of trade in indexed bonds: i.e., conditions under which there is no trade in indexed bonds in any equilibrium; only nominal bonds are traded.

Authors: Mukerji, S; Tallon, J

• Publisher: Springer Verlag
• Host title: Essays in Dynamic General Equilibrium Theory: Festschrift for David Cass
• Pages: 143 - 180
• Publication date: 2005-01-01
• ISSN: 978-3-540-22267-5
• Language: English