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Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

66 Pages Posted: 15 Sep 2016 Last revised: 19 Dec 2016

Lorenzo Bretscher

London School of Economics & Political Science (LSE)

Alex C. Hsu

Georgia Institute of Technology - Scheller College of Business

Andrea Tamoni

London School of Economics & Political Science (LSE)

Date Written: December 13, 2016

Abstract

We estimate a New-Keynesian model with heterogeneous agents to study the impact of level and volatility shocks to fiscal policy on the term structure of interest rates and bond risk premia. We derive three key insights from the theoretical model. First, government spending level shocks generate positive covariance between marginal utility to consume and inflation, making nominal bonds poor hedges against consumption risk and result in positive risk premium. Second, variability in the nominal term premium is caused by variation in the real term premium while inflation risk premium is remarkably stable over time. Fluctuation of the real term premium is entirely driven by government spending volatility shocks. Third, at the zero lower bound (ZLB), impact of level and volatility shocks to government spending are amplified. This is especially pronounced for volatility shocks producing substantial bond risk premium when the ZLB is binding.

Keywords: Term structure, Uncertainty, Fiscal Policy, Monetary Policy, DSGE Estimation

JEL Classification: E10, E30, C11

Suggested Citation

Bretscher, Lorenzo and Hsu, Alex C. and Tamoni, Andrea, Level and Volatility Shocks to Fiscal Policy: Term Structure Implications (December 13, 2016). 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 C. 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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