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Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

83 Pages Posted: 15 Sep 2016 Last revised: 5 Nov 2017

Lorenzo Bretscher

London School of Economics & Political Science (LSE)

Alex Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: November 4, 2017

Abstract

We study the impact of fiscal policy shocks on bond risk premia. Government spending level shocks generate positive covariance between marginal utility and inflation (term structure level effect) making nominal bonds a poor hedge against consumption risk leading to positive inflation risk premia. Volatility shocks to spending have strong slope effect (steepening) on the yield curve, producing positive nominal term premia. For level and volatility shocks to capital income tax, term structure level effects dominate, delivering negative risk premia. Fluctuations in term premia are entirely driven by volatility shocks. Lastly, fiscal shocks are amplified at the zero lower bound.

Keywords: Term structure, Bond Risk Premia, Uncertainty, Fiscal Policy

JEL Classification: E62, G12

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex and Tamoni, Andrea, Level and Volatility Shocks to Fiscal Policy: Term Structure Implications (November 4, 2017). Available at SSRN: https://ssrn.com/abstract=2838667 or http://dx.doi.org/10.2139/ssrn.2838667

Lorenzo Bretscher

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Alex Hsu

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

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

Andrea Tamoni (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
02079557303 (Phone)

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