Working Paper Series Money Illusion: A Rationale for the TIPS Puzzle Abraham Lioui Andrea Tarelli WP-18-001 Money Illusion: A Rationale for the TIPS Puzzle∗ Abraham Lioui† Andrea Tarelli‡ June 2018 ∗We would like to thank Francesco Corielli, Carlo Favero, Massimo Guidolin, Christian Julliard, Lucia Spotorno, Alessandro Sbuelz, Claudio Tebaldi, Tyler Shumway, as well as several seminar participants and anonymous referees for very useful comments. We are solely responsible for any remaining errors. †EDHEC Business School, 393 Promenade des Anglais, 06202 Nice Cedex 3, France. Phone: +33 (0)4 93 18 78 68. Fax: + 33 (0)4 93 83 08 10. E-mail:
[email protected]. ‡Catholic University of Milan, Largo A. Gemelli 1, 20123 Milan, Italy. Phone: +39 02 7234 2923. E-mail: an-
[email protected]. Money Illusion: A Rationale for the TIPS Puzzle Abstract Why is the TIPS market so small? We show that a rational agent, dynamically investing into multiple asset classes over a 20-year horizon, benefits by 1.2% per annum from having access to inflation-indexed bonds. However, if the investor suffers from money illusion, the perceived certainty equivalent gains reduce to less than 0.3%. Furthermore, the benefits become totally negligible if the money-illusioned investor is less sophisticated and ignores time variations in risk premia. Money illusion causes significant portfolio shifts from inflation-indexed toward nominal bonds, with little effects on equity allocations. JEL classification: E43, E52, G11, G12. Keywords: Money illusion, Term structure of interest rates, Portfolio choice. 1 1 Introduction Introduced in the U.S. in 1997, after several periods of high inflation uncertainty, Treasury Inflation- Protected Securities (TIPS) should have been acclaimed by market participants.