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

Abstract

We present a theory in which limited risk sharing of idiosyncratic labor income risk plays a key role in determining the dynamics of interest rates. Our production-based model relates the cross-sectional distribution of labor income risk to observable aggregate labor market variables. 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 a negative correlation between current labor market conditions (as measured by labor market tightness or the job-finding rate) and future bond excess returns. We provide evidence for these predictions.

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

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