General Equilibrium Properties of the Term Structure of Interest Rates

In a sequential general equilibrium with a single representative risk--averse consumer, stationary uncertainty, a one-period lag between investment and production, and concave production functions, we show that the forward price of a one-period real default-free bond one period hence is less than the expected price of the bond, if markets are locally complete and utility is state-independent. Thus the real term structure premium is always positive. This result is consistent with the "Liquidity hypothesis." However it is not based on any assumptions about the nature of risk or on time-dependent consumption preferences. The term structure is positive because long-term bonds turn out to be a poor wealth hedge, because of the way consumers allocate consumption and investment over time. The results hold for real interest rates in complete markets, with whatever pattern of (possibly time-dependent) discount factors the consumer has. In incomplete markets the results will also hold, as long as the utility function exhibits either constant or increasing absolute risk aversion. The nominal term structure is also explored for a class of money demand specifications. The value and sign of the term structure premium critically depend on changes in the supply of money. Thus the nominal term structure premium may be negative even if the real term structure premium is positive.