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

64 Pages Posted: 9 Feb 2019 Last revised: 22 Jun 2021

See all articles by Indrajit Mitra

Indrajit Mitra

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Yu Xu

University of Delaware

Date Written: June 17, 2021

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

Suggested Citation

Mitra, Indrajit and Xu, Yu, A Theory of the Term Structure of Interest Rates under Limited Household Risk Sharing (June 17, 2021). Available at SSRN: https://ssrn.com/abstract=3324765 or http://dx.doi.org/10.2139/ssrn.3324765

Indrajit Mitra

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

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

Yu Xu (Contact Author)

University of Delaware ( email )

Alfred Lerner College of Business and Economics
Newark, DE 19716
United States

HOME PAGE: http://https://www.yuxufinance.net/

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