INFLATION MEASUREMENT,INFLATION RISK,AND THE PRICING OF TREASURY BILLS

One explanation for the high real interest rates on Treasury bills during the period from 1980 to 1985 is that the risk premium had risen. A procedure for testing this hypothesis is to apply the Black version of the capital asset pricing model to real Treasury bill returns. This paper examines that procedure in detail. The main conclusion is that nonstationarity and measurement error, which are always impediments to empirical implementation of the CAPM, are particularly difficult to handle when estimating changes in Treasury bill risk premiums. Furthermore, the behavior of the premium depends on the index used to measure inflation.