Abstract
This paper proposes a testable continuous-time term-structure model with recursive utility to investigate structural relationships between the real economy and the term structure of real and nominal interest rates. In a representative-agent model with recursive utility and mean-reverting expectations on real output growth and inflation, this paper shows that, if (1) real short-term interest rates are high during economic booms and (2) the agent is comparatively risk-averse (less risk-averse) relative to time-separable utility, then a real yield curve slopes down (slopes up, respectively). Additionally, for the comparatively risk-averse agent, if (3) expected inflation is negatively correlated with the real output and its expected growth, then a nominal yield curve can slope up, regardless of the slope of the real yield curve.
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We all are thankful to Marco Cagetti, Lars Hansen, Andy Levin, Monika Piazzesi, Tack Yun, and participants of the seminar at the Federal Reserve Board of Governors for their valuable comments.
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Nakamura, H., Nakayama, K. & Takahashi, A. Term Structure of Interest Rates Under Recursive Preferences in Continuous Time. Asia-Pac Financ Markets 15, 273–305 (2008). https://doi.org/10.1007/s10690-009-9082-8
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DOI: https://doi.org/10.1007/s10690-009-9082-8