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Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

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  • Lorenzo Bretscher

    (London School of Economics)

  • Alex Hsu

    (Georgia Institute of Technology)

  • Andrea Tamoni

    (London School of Economics)

Abstract

We estimate a New-Keynesian model with heterogeneous agents to study the impact of level and volatility shocks to fiscal policy on the term structure of interest rates and bond risk premia. We derive three key insights from the theoretical model. First, government spending level shocks generate positive covariance between marginal utility to consume and inflation, making nominal bonds poor hedges against consumption risk and result in positive risk premium. Second, variability in the nominal term premium is caused by variation in the real term premium while inflation risk premium is remarkably stable over time. Fluctuation of the real term premium is entirely driven by government spending volatility shocks. Third, at the zero lower bound (ZLB), impact of level and volatility shocks to government spending are amplified. This is especially pronounced for volatility shocks producing substantial bond risk premium when the ZLB is binding.

Suggested Citation

  • Lorenzo Bretscher & Alex Hsu & Andrea Tamoni, 2017. "Level and Volatility Shocks to Fiscal Policy: Term Structure Implications," 2017 Meeting Papers 258, Society for Economic Dynamics.
  • Handle: RePEc:red:sed017:258
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