Interest rates, moneyness, and the Fisher equation

The Euler equation of a representative consumer is at the heart of modern macroeconomics. But in empirical applications, it is badly misapplied: it prices a bond that is short-term, perfectly safe, yet perfectly illiquid. Such a bond does not exist. Real-world safe assets are highly tradable or pledgeable as collateral, hence their prices reflect their moneyness as much as their dividends. Indeed, I estimate the return on a hypothetical illiquid bond, for the postwar United States, via inflation and consumption growth, and show that it behaves very differently from the return on safe and liquid assets. I also argue that this distinction helps resolve every puzzle ever associated with the Euler equation (or its long-run counterpart, the Fisher equation), and points to a better way of understanding how monetary policy affects the economy.