Term structure dynamics in a monetary economy with learning

Abstract

This paper investigates a continuous-time monetary asset-pricing model of the term structure of nominal interest rates. In a pure exchange economy with incomplete information, investors cannot observe the expected growth rates of both exogenous real output and money supply. Therefore, they apply dynamic Bayesian inference. The model obtains explicit solutions for equilibrium prices of consumption goods and nominal bonds, and the stochastic process of an investor’s beliefs. The dependence of term premia on beliefs allows the model to introduce a GARCH property, which interacts with the volatility of the macro variables. In particular, the volatility of excess returns is inversely related to noise in the macro variables, suggesting that their imprecise information does not increase fluctuations in interest rates. Using beliefs as the factor of uncertainties in economic states, the model also shows that there is a negative correlation between the new measure of uncertainty and the velocity of money, consistent with Friedman’s explanation that demand for money for precautionary motives has a negative impact on the velocity.