The Long-run Risk Model: Dynamics and Cyclicality of Interest Rates

This paper shows that the long-run risk model of Bansal and Yaron (2004) is able to simultaneously explain the dynamics and cyclical properties of interest rates and the level and volatility of equity returns. Specifically, the model accounts for deviations from the expectations hypothesis of interest rates, the upward sloping nominal yield curve, the downward sloping term structure of volatility and the predictive power of the yield spread. Real (nominal) rates are positively (negatively) correlated with consumption growth and the nominal yield spread predicts future real consumption growth, excess stock returns and inflation. The cyclical properties of nominal interest rates are shown to critically depend on the value of the elasticity of intertemporal substitution and on the correlation between consumption and inflation. The driving forces of the model are uncertainty about expected consumption growth, time-varying volatility of consumption growth and deviations from the Fisher hypothesis.