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date: 18 March 2019

Abstract and Keywords

This chapter integrates two traditional explanations for the mean and variability of the term premium into a medium-scale DSGE model: (i) time-varying risk premiums on long bonds and (ii) segmented markets between short and long bond markets. Two sources of business cycle variability, shocks to total factor productivity (TFP) and the marginal efficiency of investment (MEI), are included. The authors characterize the ability of each approach to match both the mean and the variability of the term premium when either shock is the driving source of variation in the model. The risk approach fails with a negative average term premium in response to MEI shocks and trivially small variability in the term premium overall. In contrast, the segmented markets model can easily match both moments. Market segmentation reflects a real distortion, thus smoothing the term premium is typically welfare-improving, although there are potential difficulties with such a policy.

Keywords: term premium, term premium peg, time-varying risk premiums, DSGE, total factor productivity, marginal efficiency of investment, monetary policy

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