Money Illusion and TIPS Demand

The market demand for the Treasury Inflation-Protected Securities (TIPS) is rather small. This puzzling, as we show that an agent, who derives utility from real wealth and dynamically invests into multiple asset classes over a 30-year horizon, incurs certainty equivalent loss of 1.6% per annum not investing in inflation-indexed bonds. However, if investor suffers money illusion, perceived only 0.5% annum. Furthermore, totally negligible unsophisticated money-illusioned ignoring time variation risk premia. Money illusion causes significant portfolio shifts toward nominal bonds, with little effects on equity allocations, contributing to low TIPS.