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

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.