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Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates

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  • Indrajit Mitra
  • Yu Xu

Abstract

We present a theory in which limited risk sharing of idiosyncratic labor income risk plays a key role in determining the dynamics of interest rates. Our production-based model relates the cross-sectional distribution of labor income risk to observable aggregate labor market variables. Our model makes two key predictions. First, it predicts positive risk premia for long-term bonds while simultaneously matching key macroeconomic moments. Second, it predicts a negative correlation between current labor market conditions (as measured by labor market tightness or the job-finding rate) and future bond excess returns. We provide evidence for these predictions.

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  • Indrajit Mitra & Yu Xu, 2020. "Limited Household Risk Sharing: General Equilibrium Implications for the Term Structure of Interest Rates," FRB Atlanta Working Paper 2020-20, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:89452
    DOI: 10.29338/wp2020-20
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    More about this item

    Keywords

    interest rates; nondiversifiable labor income risk; labor market frictions; bond risk premia;
    All these keywords.

    JEL classification:

    • A12 - General Economics and Teaching - - General Economics - - - Relation of Economics to Other Disciplines
    • 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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