General Equilibrium Theory of the Term Structure of Interest Rates.

Abstract

This dissertation consists of three essays examining the interactions between macroeconomy and the term structure of interest rates. In the first two theoretical essays, I investigate the effects of fiscal policy and monetary policy on the nominal and real yield curves. In the first essay on fiscal policy, bond supply and the government spending shock drive bond risk premia in a production economy where a fraction of the households are constrained to consume their entire after-tax labor income. Ricardian equivalence breaks down in the model, and fiscal policy becomes relevant to the real economy. This friction increases the consumption risk of the marginal pricers, and it results in large term premia on nominal bonds. In the second essay, co-authored with Erica Li and Francisco Palomino, the influence of monetary policy on the real term premia and the inflation risk premia is studied in the New-Keynesian framework with nominal wage and price rigidities. Under rigidities, both the monetary policy shock and the permanent productivity shock generate positive covariances between the marginal utility to consume and real long-term yields, leading to positive real term premia. However, their implications on inflation risk premia are the opposite: policy shocks generate negative inflation risk premia while permanent productivity shocks generate positive inflation risk premia. The final essay, which is empirical, tests the expectations hypothesis of the term structure by examining bond return predictability using fiscal policy variables. Built on the theory provided in the first essay, I regress excess bond returns on government spending shocks and revenue shocks as well as the conditional volatility on the spending shocks. I find evidence against the expectations hypothesis in that fiscal policy shocks have explanatory power on future bond returns. The result is robust after controlling for monetary policy as well as financial variables such as the Cochrane and Piazzesi (2005) ``return-forecasting" factor.