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The Impact of Monetary Policy on Bond Returns Volatility: A Segmented Markets Approach

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  • Bruce Mizrach

    ()
    (Rutgers University)

  • Filippo Occhino

    ()
    (Rutgers University)

Abstract

This paper assesses the contribution of monetary policy to bond returns volatility, assuming that the monetary authority controls the short-term nominal interest rate. We model exogenously the joint process for the aggregate endowment and the nominal interest rate, and we determine endogenously bond real returns. We introduce markets segmentation assuming that some households are permanently excluded from ¯nancial markets. With full participation, real returns are determined by the aggregate endow- ment only, so monetary policy can a®ect them only through its e®ect on the aggregate endowment. When markets are segmented, however, monetary policy has a direct liquidity effect on the participants' marginal utility, on the stochastic discount factor, and on real returns. The smaller the fraction of participants in the economy, the larger the impact of monetary policy. When the relative risk aversion parameter is set to values estimated in experimental micro studies, the full participation model cannot replicate bond returns volatility, while the segmented markets model can fully account for the apparent excess volatility of short-term bond returns.

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Bibliographic Info

Paper provided by Rutgers University, Department of Economics in its series Departmental Working Papers with number 200402.

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Length: 20 pages
Date of creation: 31 Jan 2004
Date of revision:
Publication status: Published in Journal of Economics and Business 60, 2008, 485-501.
Handle: RePEc:rut:rutres:200402

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Keywords: bond returns volatility; limited participation; segmented markets; monetary policy shocks;

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  1. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  2. Filippo Occhino, 2004. "Modeling the Response of Money and Interest Rates to Monetary Policy Shocks: A Segmented Markets Approach," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(1), pages 181-197, January.
  3. Charles A. Holt & Susan K. Laury, 2002. "Risk Aversion and Incentive Effects," American Economic Review, American Economic Association, vol. 92(5), pages 1644-1655, December.
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