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A Theory of the Term Structure of Interest Rates under Limited Household Risk Sharing

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  • Indrajit Mitra
  • Yu Xu

Abstract

We present a theory in which the interaction between limited sharing of idiosyncratic labor income risk and labor adjustment costs (that endogenously arise through search frictions) determines interest rate dynamics. In the general equilibrium, the interaction of these two ingredients relates bond risk premiums, cross-sectional skewness of income growth, and labor market tightness. Our model rationalizes an upward-sloping average yield curve and predicts a negative relation between labor market tightness and bond risk premiums. We provide evidence for our theory’s mechanism and predictions.

Suggested Citation

  • Indrajit Mitra & Yu Xu, 2024. "A Theory of the Term Structure of Interest Rates under Limited Household Risk Sharing," The Review of Financial Studies, Society for Financial Studies, vol. 37(8), pages 2461-2509.
    • Handle: RePEc:oup:rfinst:v:37:y:2024:i:8:p:2461-2509.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhae011
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    More about this item

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • 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
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search

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