Changes in Price Expectations: Some Tests Using Data on Indexed and Non-Indexed Bonds

Abstract

The role of price expectations is given a prominent position in a large body of theoretical and empirical research. The lack of direct data on expectations has made it necessary to rely on proxies which are derived from various hypotheses about the formation of expectations. A few studies (Turnovsky, 1970; Turnovsky and Wachter, 1972; Knobl, 1974; Carlson and Parkin, 1975) have, however, produced data on price expectations constructed directly from survey material. From the end of the Second World War until 1968 the Finnish Government issued both indexed and non-indexed bonds. The index clause generally provided for 50 per cent compensation for rises in the consumer price index. This meant that every rise of 2 per cent in the cost of living index brings a 1 per cent rise in interest payments and amortization (Bank of Finland, 1969). In this study we used the yield differentials between indexed and non-indexed bonds as a source of information on price expectations. The yield differentials cannot be directly taken as a measure of the expected index linkage increments of the indexed bonds because the uncertainty about future prices also exercises an influence on yields. After adjusting for uncertainty, we constructed a monthly series for price expectations over the period 1963-1974. We then tested some hypotheses about expectations formation with the aid of this series.