Term Premium Variability and Monetary Policy

39 Pages Posted: 30 May 2016

See all articles by Timothy S. Fuerst

Timothy S. Fuerst

University of Notre Dame

Ronald Mau

Federal Reserve Banks - Federal Reserve Bank of Dallas

Date Written: May 6, 2016

Abstract

Two traditional explanations for the mean and variability of the term premium are: (i) time-varying risk premia on long bonds, and (ii) segmented markets between long- and short-term bonds. This paper integrates these two approaches into a medium-scale DSGE model. We consider two sources of business cycle variability: shocks to total factor productivity (TFP), and shocks to the marginal efficiency of investment (MEI). The ability of the risk approach to match the first moment of the term premium depends upon the relative importance of these two shocks. If MEI shocks are an important driver of the business cycle, then long bonds are a hedge against the business cycle so that the average term premium is negative. The opposite is the case for the TFP shocks. But for either source of shocks, the risk approach to the term premium predicts a trivial amount of variability in the term premium. In contrast, the segmented markets model can easily match both moments. The market segmentation reflects a real distortion, so that smoothing the term premium is typically welfare-improving. There are two difficulties with such a policy. First, the mean level of the term premium will not properly reflect the segmentation distortion because of the risk adjustment. Second, if the term premium is measured with error, the welfare gain of a term premium peg is naturally reduced. The paper demonstrates that both of these effects are quantitatively modest so that the welfare advantage to a term premium peg survives.

Keywords: term premium peg, time-varying risk premia, DSGE, total factor productivity, marginal efficiency of investment, monetary policy

JEL Classification: E52, G12, G17

Suggested Citation

Fuerst, Timothy S. and Mau, Ronald, Term Premium Variability and Monetary Policy (May 6, 2016). FRB of Cleveland Working Paper No. 16-11, Available at SSRN: https://ssrn.com/abstract=2785759 or http://dx.doi.org/10.2139/ssrn.2785759

Timothy S. Fuerst (Contact Author)

University of Notre Dame ( email )

Notre Dame, IN 46556
United States

Ronald Mau

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
84
Abstract Views
911
Rank
634,655
PlumX Metrics