THE TERM-STRUCTURE OF INTEREST RATES AND EXPECTATIONS OF PRICE INCREASE AND DEVALUATION.

In an unstable economy, expectations of changes in price level and rate of exchange play a significant role in motivating the economic behavior of both households and firms. Several econometric studies attempted to predict future expectations on the basis of past observations. Such studies, however, are crucially dependent on the assumptions (1) that there has been a relationship between past performance and expectations, and (2) that the nature of this relationship is known. Another method for the estimation of expectations is the one which derives these expectations on the basis of the price structure of future markets. However, an examination of specific commodities traded on future markets does not provide meaningful estimates, since their future prices reflect, among other things, expected changes in relative prices. This problem can be circumvented by referring to future interest rates which can be derived from the market price structure of financial assets. This paper sets out the theoretical relationship between yields on unlinked and linked bonds, showing that it reflects market expectations of future rates of change in price level and exchange rate. A model is then used to show theoretically that it is possible to derive estimations of market expectations regarding such future rates of change by comparing the yields of unlinked bonds with the yields of bonds linked to the price level and the foreign exchange rate respectively, provided these bonds are identical in all other respects. [ABSTRACT FROM AUTHOR]