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

50 Pages Posted: 20 Apr 2021

See all articles by Indrajit Mitra

Indrajit Mitra

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Yu Xu

University of Delaware

Date Written: November 2020

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

Suggested Citation

Mitra, Indrajit and Xu, Yu, Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates (November 2020). FRB Atlanta Working Paper No. 2020-20, Available at SSRN: https://ssrn.com/abstract=3829915 or http://dx.doi.org/10.2139/ssrn.3829915

Indrajit Mitra (Contact Author)

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

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

Yu Xu

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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