Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates

63 Pages Posted: 9 Feb 2019 Last revised: 30 Dec 2019

See all articles by Indrajit Mitra

Indrajit Mitra

University of Michigan, Stephen M. Ross School of Business

Yu Xu

The University of Hong Kong - Faculty of Business and Economics

Date Written: December 30, 2019

Abstract

We propose a theory of real interest rates in which non-diversifiable idiosyncratic labor income risk is a key determinant of interest rate risk. Our production-based model relates the distribution of labor income risk in the cross-section of individuals to aggregate labor market conditions. Our model makes two key predictions. First, it predicts positive risk premia for long-term bonds while simultaneously matching key macroeconomic moments. Second, it predicts that a decline in labor market conditions, as reflected by low aggregate employment growth, job-finding rate, and labor market tightness, forecasts higher bond excess returns. These predictions are in line with empirical evidence.

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, Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates (December 30, 2019). Available at SSRN: https://ssrn.com/abstract=3324765 or http://dx.doi.org/10.2139/ssrn.3324765

Indrajit Mitra

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Yu Xu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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