Scottish Journal of Political Economy, Dec 14, 2021
Long‐term bond yields contain a risk premium, an important part of which is compensation for infl... more Long‐term bond yields contain a risk premium, an important part of which is compensation for inflation risks. The substantial increase in the Fed funds rate in the mid‐2000s did not raise long‐term US Treasury yields due to the reduction in the term premium (so‐called Greenspan conundrum) which was typically thought to be exogenous for monetary policy. We show using a New Keynesian macro‐finance model that the term premium is endogenous and is greatly influenced by the specification of the Taylor rule. Finally, we estimate our model using various specifications of Taylor rule on US data in 1961–2007 by the generalized methods of moments and evaluate the performance of our model.
We explore asset pricing implications of productive, wasteful and utility enhancing government ex... more We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current consumption gains against future losses. In a special case where the central bank does not respond to changes in output bonds leverage inflation risk. Spending reversals strongly reduce the sensitivity of bond prices to changes in government spending.
Survey evidence tells us that stock prices reflect the risks investors associate with long-run te... more Survey evidence tells us that stock prices reflect the risks investors associate with long-run technological change. However, there is a shortage of models that can rationalize long-run risks. Unlike the previous literature assuming a fixed number of products, our model allows for new product varieties that appear in the form of new firms which face entry costs and delay in the entry process. The fixed variety model has a significant limitation in translating macroeconomic volatility into asset return volatility. Our model with growing varieties induces endogenous low-frequency fluctuations in productivity driving large, persistent variations in consumption growth and asset prices. It also changes the valuation of assets through the increase in the volatility of the pricing kernel (with a positive long-run component) and leads to higher excess returns. Our model is motivated by a simple recursively identified VAR model containing quarterly US data 1992Q3-2018Q4 with the following li...
Long‐term bond yields contain a risk premium, an important part of which is compensation for infl... more Long‐term bond yields contain a risk premium, an important part of which is compensation for inflation risks. The substantial increase in the Fed funds rate in the mid‐2000s did not raise long‐term US Treasury yields due to the reduction in the term premium (so‐called Greenspan conundrum) which was typically thought to be exogenous for monetary policy. We show using a New Keynesian macro‐finance model that the term premium is endogenous and is greatly influenced by the specification of the Taylor rule. Finally, we estimate our model using various specifications of Taylor rule on US data in 1961–2007 by the generalized methods of moments and evaluate the performance of our model.
We introduce costly …rm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-... more We introduce costly …rm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-Zin preferences and show that it can jointly account for a high mean value of bond and equity premium without compromising the …t of the model to …rst and second moments of key macroeconomic variables. In the standard New Keynesian model without entry it is easy to generate in‡ation risks on long-term nominal bonds when placing high coe¢ cient on the output gap in the Taylor rule. Our model is able to generate in‡ation risks when the coe¢ cient on the output gap is small. In the entry model real risks are lower than in the standard New Keynesian model without entry due to the appearance of new varieties that help households smooth their consumption better.
Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a k... more Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a key determinant of term structure, we introduce trend inflation into the workhorse macro-finance model. We show that this compromises the earlier model success and delivers implausible business cycle and bond price dynamics. We document that this result applies more generally to non-linearly solved models with Calvo pricing and trend inflation and is driven by the behavior of price dispersion, which is i) counterfactually high and ii) highly inaccurately approximated. We highlight the channels behind the undesired performance under trend inflation and propose several remedies.
We explore asset pricing implications of productive, wasteful and utility enhancing government ex... more We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current con...
We introduce costly firm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein... more We introduce costly firm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-Zin preferences and show that it can jointly account for a high mean value of bond and equity premium without compromising the fit of the model to first and second moments of key macroeconomic variables. In the standard New Keynesian model without entry it is easy to generate inflation risks on long-term nominal bonds when placing high coefficient on the output gap in the Taylor rule. Our model is able to generate inflation risks when the coefficient on the output gap is small. In the entry model real risks are lower and inflation risks are ceteris paribus higher than in the standard New Keynesian model without entry due to the appearance of new varieties that help households smooth their consumption better.
Scottish Journal of Political Economy, Dec 14, 2021
Long‐term bond yields contain a risk premium, an important part of which is compensation for infl... more Long‐term bond yields contain a risk premium, an important part of which is compensation for inflation risks. The substantial increase in the Fed funds rate in the mid‐2000s did not raise long‐term US Treasury yields due to the reduction in the term premium (so‐called Greenspan conundrum) which was typically thought to be exogenous for monetary policy. We show using a New Keynesian macro‐finance model that the term premium is endogenous and is greatly influenced by the specification of the Taylor rule. Finally, we estimate our model using various specifications of Taylor rule on US data in 1961–2007 by the generalized methods of moments and evaluate the performance of our model.
We explore asset pricing implications of productive, wasteful and utility enhancing government ex... more We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current consumption gains against future losses. In a special case where the central bank does not respond to changes in output bonds leverage inflation risk. Spending reversals strongly reduce the sensitivity of bond prices to changes in government spending.
Survey evidence tells us that stock prices reflect the risks investors associate with long-run te... more Survey evidence tells us that stock prices reflect the risks investors associate with long-run technological change. However, there is a shortage of models that can rationalize long-run risks. Unlike the previous literature assuming a fixed number of products, our model allows for new product varieties that appear in the form of new firms which face entry costs and delay in the entry process. The fixed variety model has a significant limitation in translating macroeconomic volatility into asset return volatility. Our model with growing varieties induces endogenous low-frequency fluctuations in productivity driving large, persistent variations in consumption growth and asset prices. It also changes the valuation of assets through the increase in the volatility of the pricing kernel (with a positive long-run component) and leads to higher excess returns. Our model is motivated by a simple recursively identified VAR model containing quarterly US data 1992Q3-2018Q4 with the following li...
Long‐term bond yields contain a risk premium, an important part of which is compensation for infl... more Long‐term bond yields contain a risk premium, an important part of which is compensation for inflation risks. The substantial increase in the Fed funds rate in the mid‐2000s did not raise long‐term US Treasury yields due to the reduction in the term premium (so‐called Greenspan conundrum) which was typically thought to be exogenous for monetary policy. We show using a New Keynesian macro‐finance model that the term premium is endogenous and is greatly influenced by the specification of the Taylor rule. Finally, we estimate our model using various specifications of Taylor rule on US data in 1961–2007 by the generalized methods of moments and evaluate the performance of our model.
We introduce costly …rm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-... more We introduce costly …rm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-Zin preferences and show that it can jointly account for a high mean value of bond and equity premium without compromising the …t of the model to …rst and second moments of key macroeconomic variables. In the standard New Keynesian model without entry it is easy to generate in‡ation risks on long-term nominal bonds when placing high coe¢ cient on the output gap in the Taylor rule. Our model is able to generate in‡ation risks when the coe¢ cient on the output gap is small. In the entry model real risks are lower than in the standard New Keynesian model without entry due to the appearance of new varieties that help households smooth their consumption better.
Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a k... more Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a key determinant of term structure, we introduce trend inflation into the workhorse macro-finance model. We show that this compromises the earlier model success and delivers implausible business cycle and bond price dynamics. We document that this result applies more generally to non-linearly solved models with Calvo pricing and trend inflation and is driven by the behavior of price dispersion, which is i) counterfactually high and ii) highly inaccurately approximated. We highlight the channels behind the undesired performance under trend inflation and propose several remedies.
We explore asset pricing implications of productive, wasteful and utility enhancing government ex... more We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current con...
We introduce costly firm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein... more We introduce costly firm-entry a la Bilbiie et al. (2012) into a New Keynesian model with Epstein-Zin preferences and show that it can jointly account for a high mean value of bond and equity premium without compromising the fit of the model to first and second moments of key macroeconomic variables. In the standard New Keynesian model without entry it is easy to generate inflation risks on long-term nominal bonds when placing high coefficient on the output gap in the Taylor rule. Our model is able to generate inflation risks when the coefficient on the output gap is small. In the entry model real risks are lower and inflation risks are ceteris paribus higher than in the standard New Keynesian model without entry due to the appearance of new varieties that help households smooth their consumption better.
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