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Time-Varying Risk Aversion and Inflation-Consumption Correlation in an Equilibrium Term Structure Model

Author

Listed:
  • Tilman Bletzinger
  • Wolfgang Lemke
  • Jean-Paul Renne

Abstract

Inflation risk premiums tend to be positive in an economy mainly hit by supply shocks, and negative if demand shocks dominate. Risk premiums also fluctuate with risk aversion. We shed light on this nexus in a linear-quadratic equilibrium macro-finance model featuring time variation in inflation-consumption correlation and risk aversion. We obtain analytical solutions for real and nominal yield curves and for risk premiums. While changes in the inflation-consumption correlation drive nominal yields, changes in risk aversion drive real yields and act as amplifier on nominal yields. Combining a trend-cycle specification of real consumption with hysteresis effects generates an upward-sloping real yield curve. Estimating the model on U.S. data from 1961 to 2019 confirms substantial time variation in inflation risk premiums: distinctly positive in the earlier part of our sample, especially during the 1980s, and turning negative with the onset of the new millennium.

Suggested Citation

  • Tilman Bletzinger & Wolfgang Lemke & Jean-Paul Renne, 2025. "Time-Varying Risk Aversion and Inflation-Consumption Correlation in an Equilibrium Term Structure Model," Journal of Financial Econometrics, Oxford University Press, vol. 23(2), pages 110-138.
  • Handle: RePEc:oup:jfinec:v:23:y:2025:i:2:p:110-138.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbae038
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    More about this item

    Keywords

    term structure model; inflation risk premiums; demand and supply; risk aversion;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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