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What is the real story for interest rate volatility?

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  • Andreas Hornstein
  • Harald Uhlig

Abstract

What is the source of interest rate volatility? Why do low interest rates precede business cycle booms? Most observers tend to assume that monetary policy is largely responsible for it. Indeed, a standard real business cycle model delivers rather small fluctuations in real interest rates. Here, however, we present two models of the real business cycle variety in which real rate fluctuations are of similar magnitude as in the data, while simultaneously matching salient business cycle facts. The second model also replicates the cyclical behavior of real interest rates. The models build on recent work by Danthine-Donaldson, Jermann, and Boldrin-Christiano-Fisher. We assume that there are workers and capital owners. The first model posits habit formation and adjustment costs to the stock of capital. The second model assumes that it takes time to plan investment and time to build capital.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 99-09.

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Date of creation: 1999
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Handle: RePEc:fip:fedrwp:99-09

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Related research

Keywords: Interest rates ; Capital market ; Macroeconomics;

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References

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  1. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  2. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  3. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  4. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  5. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
  6. Lettau, Martin & Uhlig, Harald, 1997. "Preferences, Consumption Smoothing, and Risk Premia," CEPR Discussion Papers 1678, C.E.P.R. Discussion Papers.
  7. Mankiw, N. Gregory & Zeldes, Stephen P., 1991. "The consumption of stockholders and nonstockholders," Journal of Financial Economics, Elsevier, vol. 29(1), pages 97-112, March.
  8. Wouter J. Den Haan, 1996. "Understanding Equilibrium Models with a Small and a Large Number of Agents," NBER Working Papers 5792, National Bureau of Economic Research, Inc.
  9. den Haan, Wouter J., 1995. "The term structure of interest rates in real and monetary economies," Journal of Economic Dynamics and Control, Elsevier, vol. 19(5-7), pages 909-940.
  10. John H Cochrane, 2003. "Where is the Market Going: Uncertain Facts and Novel Theories," Levine's Working Paper Archive 618897000000000762, David K. Levine.
  11. Jean-Pierre DANTHINE & John B. DONALDSON & Rajnish MEHRA, 1992. "The Equity Premium and the Allocation of Income Risk," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9203, Université de Lausanne, Faculté des HEC, DEEP.
  12. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  13. Rogerson, Richard, 1988. "Indivisible labor, lotteries and equilibrium," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 3-16, January.
  14. Gary Hansen, 2010. "Indivisible Labor and the Business Cycle," Levine's Working Paper Archive 233, David K. Levine.
  15. Stock, James H. & Watson, Mark W., 1999. "Business cycle fluctuations in us macroeconomic time series," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 1, pages 3-64 Elsevier.
  16. S.G. Cecchetti & P. Lam & N.C. Mark, 2010. "The equity premium and the risk-free rate: matching the moments," Levine's Working Paper Archive 1396, David K. Levine.
  17. King, Robert G & Watson, Mark W, 1996. "Money, Prices, Interest Rates and the Business Cycle," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 35-53, February.
  18. Lusardi, Annamaria, 1998. "On the Importance of the Precautionary Saving Motive," American Economic Review, American Economic Association, vol. 88(2), pages 449-53, May.
  19. Mulligan, Casey B & Sala-i-Martin, Xavier, 1996. "Adoption of Financial Technologies: Implications for Money Demand and Monetary Policy," CEPR Discussion Papers 1358, C.E.P.R. Discussion Papers.
  20. Danthine, J.P. & Donaldson, J.B., 1994. "Asset Pricing Implications of Real Market Frictions," Papers 95-04, Columbia - Graduate School of Business.
  21. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  22. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity, Portfolio Choice, and Equilibrium Asset Returns," GSIA Working Papers 1997-45, Carnegie Mellon University, Tepper School of Business.
  23. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  24. Lettau, M. & Uhlig, H., 1995. "Can Habit Formation be Reconciled with Business Cycle Facts?," Discussion Paper 1995-54, Tilburg University, Center for Economic Research.
  25. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  26. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February.
  27. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
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Cited by:
  1. Santiago Budría, 2008. "An Exploration of Asset Returns in a Production Economy with Relative Habits," Atlantic Economic Journal, International Atlantic Economic Society, vol. 36(3), pages 261-274, September.
  2. Scheffel, Eric, 2008. "Consumption Velocity in a Cash Costly-Credit Model," Cardiff Economics Working Papers E2008/31, Cardiff University, Cardiff Business School, Economics Section.

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