Government Spending and the Term Structure of Interest Rates in a DSGE Model

We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current consumption gains against future losses. In a special case where the central bank does not respond to changes in output bonds leverage inflation risk. Spending reversals strongly reduce the sensitivity of bond prices to changes in government spending.