Is the Real Yield Curve Inverted?

Abstract

Lengwiler (2005) presents a model of an endowment economy in which economic actors have different degrees of patience. The model implies that the social discount rate declines as the time horizon increases and that the resulting term structure of the interest rate cannot be produced by a representative agent model. This paper examines the sensitivity of Lengwiler's results to changes in the model's assumptions. In particular, it examines what sort of changes to Lengwiler's model will yield an upward sloping or even flat real yield curve. Although this paper shows that it is possible to add production to Lengwiler's model without changing the results, it also shows that the results are sensitive to the curvature of the utility function. If it is assumed that utility from consumption is logarithmic, but utility from leisure is quadratic, this paper shows that it is possible for the yield curve to be upward-sloping, downward-sloping or horizontal. Finally the paper informally explores the effect of adding capital accumulation to the model and concludes that this would reinforce the tendency for the yield curve to have a downward slope. This reinforces the general conclusion that the shape of the utility function determines the shape of the real yield curve.