Real and Nominal Equilibrium Yield Curves with Endogenous Inflation: A Quantitative Assessment

71 Pages Posted: 2 Nov 2014 Last revised: 26 Oct 2015

See all articles by Alex Hsu

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Erica X. N. Li

Cheung Kong Graduate School of Business

Francisco Palomino

University of Michigan, Stephen M. Ross School of Business

Date Written: October 15, 2014

Abstract

The links between real and nominal bond risk premia and macroeconomic dynamics are explored analytically and quantitatively in a model with nominal rigidities and monetary policy. The interest-rate policy rule becomes a restriction linking real and nominal risk premia through endogenous inflation. The estimated model captures macroeconomic and yield curve properties of the U.S. economy, implying significantly positive real term and inflation risk bond premia. Both premia are induced by wage rigidities as a compensation for permanent productivity shocks. Stronger policy-rule responses to inflation (output) increase (decrease) both premia. Policy surprises generate significant yield volatility but negligible risk premia.

Keywords: Term structure of interest rates, bond risk premia, monetary policy, nominal rigidities

JEL Classification: D51, E43, E44, E52, G12

Suggested Citation

Hsu, Alex and Li, Erica X. N. and Palomino, Francisco, Real and Nominal Equilibrium Yield Curves with Endogenous Inflation: A Quantitative Assessment (October 15, 2014). Ross School of Business Paper No. 1256. Available at SSRN: https://ssrn.com/abstract=2517572 or http://dx.doi.org/10.2139/ssrn.2517572

Alex Hsu

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States
4043851123 (Phone)

Erica X. N. Li

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Francisco Palomino (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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