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Bond Risk Premiums and Optimal Monetary Policy

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  • Francisco Palomino

    (University of Michigan)

Abstract

The bond yield dynamics implied by a welfare-maximizing monetary policy and its credibility are explored in general equilibrium. Credibility is captured by a regime change from discretion to commitment. The policy determines the optimal output and inflation responses to a source of inflation risk. Bond yields contain compensations for this risk that depend on the policy. Credibility improvements reduce the exposure to inflation risk and bond risk premiums decline. A model calibration implies lower yield spreads, less volatile yields, and reduced deviations from the expectations hypothesis under commitment. The model suggests an explanation for changes in yield dynamics in the U.S. across different policy regimes. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2010.05.003
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 15 (2012)
Issue (Month): 1 (January)
Pages: 19-40

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Handle: RePEc:red:issued:09-159

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Keywords: Affine term structure; General equilibrium; Time-varying term premiums; Monetary policy; Discretion vs. commitment;

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Cited by:
  1. Gust, Christopher & López-Salido, J David, 2010. "Monetary Policy and the Cyclicality of Risk," CEPR Discussion Papers 7727, C.E.P.R. Discussion Papers.
  2. Tanaka Hiroatsu, 2012. "Monetary Policy Regimes and the Term Structure of Interests Rates with Recursive Utility," 2012 Meeting Papers 557, Society for Economic Dynamics.
  3. Chernov, Mikhail & Mueller, Philippe, 2008. "The Term Structure of Inflation Expectations," CEPR Discussion Papers 6809, C.E.P.R. Discussion Papers.
  4. Eric T. Swanson, 2013. "Implications of labor market frictions for risk aversion and risk premia," Working Paper Series 2013-30, Federal Reserve Bank of San Francisco.
  5. Refet S. G�rkaynak & Jonathan H. Wright, 2012. "Macroeconomics and the Term Structure," Journal of Economic Literature, American Economic Association, vol. 50(2), pages 331-67, June.
  6. John Y. Campbell & Carolin Pflueger & Luis M. Viceira, 2013. "Monetary Policy Drivers of Bond and Equity Risks," Harvard Business School Working Papers 14-031, Harvard Business School, revised Apr 2014.
  7. Armand Fouejieu & Scott Roger, 2013. "Inflation Targeting and Country Risk," IMF Working Papers 13/21, International Monetary Fund.

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