Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

Abstract:     

We build and 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 estimated 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. Therefore, investors demand positive risk premium for holding inflation risk. Second, government spending volatility shocks generate negative inflation risk premium as inflation declines when the marginal utility to consume is high. Increased uncertainty in government spending causes savings to go down while investment to go up, which in turn lowers the marginal cost of production and inflation. Third, variability in the nominal term premium is driven by variation in the real term premium while inflation risk premium is remarkably stable over time. We find that fluctuation of the real term premium is entirely driven by government spending volatility shocks.

Number of Pages in PDF File: 73

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

JEL Classification: E10, E30, C11