Macroeconomic Drivers of Bond and Equity Risks
56 Pages Posted: 28 Apr 2014
Date Written: April 2014
Our new model of consumption-based habit formation preferences generates loglinear, homoskedastic macroeconomic dynamics and time-varying risk premia on bonds and stocks. Consumers' first-order condition for the real risk-free interest rate takes the form of an exactly loglinear consumption Euler equation, commonly assumed in New Keynesian models. Estimating the model separately for 1979-2001 and 2001-2011 explains why the exposure of US Treasury bonds to the stock market changed from positive to negative. A change in the comovement between inflation and the output gap explains changing bond risks, but only when risk premia change endogenously as predicted by the model.
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