A Portfolio-Balance Model of Inflation and Yield Curve Determination

We propose a portfolio-balance model of the yield curve in which inflation is determined through an interest rate rule that satisfies the Taylor principle. Because arbitrageurs care about their real wealth, they only absorb an increase in the supply of nominal bonds if they are compensated with an increase in their real rates of return. Since the Taylor principle implies that the real return on nominal bonds positively depends on inflation, inflation increases in equilibrium when there is an increase in the supply of nominal bonds to compensate arbitrageurs for the additional supply they have to hold. (JEL E43, E52, G12, H63)Received: 3 November 2022; Editorial Decision: 6 August 2024Editor: Hui ChenAuthors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.