A Theory of the Term Structure of Interest Rates under Limited Household Risk Sharing

Abstract

We present a theory in which the interaction between limited sharing of idiosyncratic labor income risk and labor adjustment costs (that endogenously arise through search frictions) determines interest rate dynamics. In the general equilibrium, the interaction of these two ingredients relates bond risk premia, cross-sectional skewness of income growth, and labor market tightness. Our model rationalizes an upward sloping average yield curve and makes two predictions: (1) a flatter real yield curve in economies with lower job-finding rates, and (2) a negative relation between labor market tightness and bond risk premia. We provide evidence for our theory's mechanism and predictions.

Keywords: Interest Rates, Nondiversifiable Labor Income Risk, Labor Market Frictions, Bond Risk Premia

JEL Classification: E24, E43, E44, G12, J64