December 2022

Equilibrium Yield Curves with Imperfect Information

Hiroatsu Tanaka


I study the dynamics of default-free bond yields and term premia using a novel equilibrium term structure model with a New-Keynesian core and imperfect information about productivity. The model generates term premia that are on average positive with sizable countercyclical variation that arises endogenously. Importantly, demand shocks, in addition to supply shocks, play a key role in the dynamics of term premia. This is in sharp contrast to existing DSGE term structure models with perfect information, which tend to rely on large supply shocks to generate timevariation in yields and term premia. With imperfect information, a shock to productivity is a supply shock, while a shock to signals about productivity that do not lead to actual changes in productivity acts as a demand shock. Nevertheless, an increase in economic activity generates more information about productivity, regardless of which type of shock it arises from. Moreover, a decrease in economic uncertainty leads to a decline in term premia as longer-term bonds are risky on average. This feature helps reconcile the empirical evidence that term premia have been on average positive and countercyclical, with numerous studies pointing to demand shocks as being an important driver of business cycles over the last few decades.

Note: On January 12, 2023, the title of the right panel of Figure 2 and the corresponding description in p.9 (lines 3 and 4) were corrected to "Patent Application Growth" from "Patent Issuance Growth."

Keywords: Term Premium, Term Structure of Interest Rates, Yield Curve, DSGE Model, Imperfect Information, Learning


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Last Update: January 12, 2023