One of the most attractive features of the recent work on option pricing, ably summarized by Cox and Ross As Black and Scholes

The demand for index bonds by households is studied in an inter-temporal optimization model in which households can choose a portfolio consisting of equity, nominal bonds, and index bonds. The rate of inflation is uncertain. In a setting where all income is from capital gains, it is shown that index bonds command a premium over nominal bonds only if equity is not a hedge against inflation; it is also shown that, if there are homogeneous expectations and no outside bonds, all lending and borrowing will be through index bonds with no nominal bonds existing. These conclusions are modified when individuals have income from human capital. The very stringent conditions under which a single index bond provides the household with the same utility as a full set of futures markets are examined in a model with many consumption goods.

A given amount of seigniorage revenue can be collected at either a high or a low rate of inflation. Thus there ray be two equilibria when a government finances its deficit by printing money--implying that an economy may be stuck in a high inflation equilibrium when, with the same fiscal policy, it could be at a lower inflation rate. We show that under rational expectations the high inflation equilibrium is stable and the low inflation equilibrium unstable; under adaptive expectations or lagged adjustment of money balances with rational expectations, it may be the low inflation equilibrium that is stable. Extending the model to allow for bond as well as money financing of deficits, we show that one of the equilibria disappears if the government sets a nominal anchor for the economy, for instance by fixing the growth rate of money. The dual equilibria and their stability.