An Estimated DSGE Model: Explaining Variation in Nominal Term Premia, Real Term Premia, and Inflation Risk Premia

Abstract

This paper develops a DSGE model which explains variation in the nominal and real term structure along with inflation surveys and four macro variables in the UK economy. The model is estimated based on a third-order approximation to allow for time-varying term premia. We find a fall in nominal term premia during the 1990's which mainly is due to lower inflation risk premia. A structural decomposition further shows that this fall is driven by negative preference shocks, lower fixed production costs, positive investment shocks, and a more aggressive response to inflation by the Bank of England.