A Monetary Explanation of the Term Structure of Interest Rates and Bond Risk Premia

Abstract

This paper presents a monetary model of the term structure of interest rates. This model is intended to explain the stylized facts in Treasury yields including counter cyclical variations of bond risk premia without challenging both short-run and long-run monetary facts. To this end, we study the roles of a segmented asset market, habit formation, and inflation targeting in a cash-in-advance model. We provide a monetary general equilibrium justification of an affine term structure model with a flexible market price of risk. Quantitative results show that the model can capture the features in the nominal term structure.