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 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