Research Discussion Paper – RDP 25 Expectations and the Demand for Government Bonds in Australia


Economists seem somewhat confused about the correct specification of the yields of various classes of asset for use in asset demand equations. Tobin's recent, mainly theoretical articles on asset choice discuss ‘rates of return’ or ‘relevant interest rates’, although much earlier he stressed the effect of both current and expected interest rates in discussing the choice between cash and consols. Empirical workers in this field frequently use ‘the expected rate of interest’ in conjunction with or as an alternative to actual rates of interest, although discussion of exactly why is rarely included. The fact that many empirical studies misspecify the demand function by including only current or expected own rates, as well as competing rates suggest there is considerable confusion about the role of each variable. Alternatively, the relative lack of success of studies that attempt to include both terms may provide a rationalization for including only one, although if this is so it is a pity the writers do not say so.

This paper argues that both current and expected yields should be included in demand equations for assets, such as government bonds, where there are significant market imperfections caused by government intervention. In such a case there can be firm expectations of a change in bond yields that will enable private bond holders to make or avoid capital gains. In the usual perfect market of economic models, a widely held expection of such a change in yields would change yields as soon as it was formed, and hence current yields would represent the ‘relevant rate of return’.

A subsidiary purpose of the paper is to examine the relative usefulness of several measures of price expectations in the demand equation for government bonds, thereby following up a suggestion in a recent article on price expectations.