No abstract

We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation-a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data.

Asset-return implications of nominal price and wage rigidities are analyzed in general equilibrium. Nominal rigidities, combined with permanent productivity shocks, increase expected excess returns on production claims. This is mainly explained by consumption dynamics driven by rigidity-induced changes in employment and markups. An interest-rate monetary policy rule affects asset returns. Stronger (weaker) rule responses to inflation (output) increase expected excess returns. Policy shocks substantially increase asset-return volatility. Price rigidity heterogeneity produces cross-sectoral differences in expected returns. The model matches important macroeconomic moments and the Sharpe ratio of stock returns, but only captures a small fraction of the observed equity premium.