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

Abstract

We propose a theory of real interest rates in which imperfect insurance of idiosyncratic labor-income risk across individual households is a key determinant of interest rate risk. Our production-based model relates the distribution of labor-income risk in the cross-section of households to firm-hiring decisions. Our model makes two key predictions. First, it predicts a positive risk-premium of long-term bonds while simultaneously matching key macro-economic 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, predict higher bond risk-premium. 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