Working Paper

Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates

Abstract: We present a theory in which limited risk sharing of idiosyncratic labor income risk plays a key role in determining the dynamics of interest rates. Our production-based model relates the cross-sectional distribution of labor income risk to observable aggregate labor market variables. Our model makes two key predictions. First, it predicts positive risk premia for long-term bonds while simultaneously matching key macroeconomic moments. Second, it predicts a negative correlation between current labor market conditions (as measured by labor market tightness or the job-finding rate) and future bond excess returns. We provide evidence for these predictions.

Keywords: interest rates; nondiversifiable labor income risk; labor market frictions; bond risk premia;

JEL Classification: A12; E24; E43; E44; G12; J64;

Status: Published in 2020

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Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 2020-11-09

Number: 2020-20