Government Spending and the Term Structure of Interest Rates in a DSGE Model

Aleš Maršál, Lorant Kaszab and Roman Horvath

No WP 3/2017, Working and Discussion Papers from Research Department, National Bank of Slovakia

Abstract: We explore asset pricing implications of productive, wasteful and utility enhancing government expenditures in a New Keynesian macro-finance model with Epstein-Zin preferences. We decompose the pricing kernel into four underlying macroeconomic factors (consumption growth, inflation, time preference shocks, long run risks for consumption and leisure) and design novel method to quantify the contribution of each factor to bond prices. Our methodology extends the performance attribution analysis typically used in finance literature on portfolio analysis. Using this framework, we show that bonds can serve as an insurance vehicle against the fluctuations in investors wealth induced by government spending. Increase in uncertainty surrounding government spending rises the demand for bonds leading to decrease in yields over the whole maturity profile. Bonds insure investors by i) providing buffer against bad times, ii) hedging inflation risk and iii) hedging real risks by putting current consumption gains against future losses. In a special case where the central bank does not respond to changes in output bonds leverage inflation risk. Spending reversals strongly reduce the sensitivity of bond prices to changes in government spending.

Keywords: Macro-finance; New Keynesian model; Government expenditures; Bond prices (search for similar items in EconPapers)
JEL-codes: C12 C22 C52 (search for similar items in EconPapers)
Pages: 82 pages
Date: 2017-09
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Government Spending and the Term Structure of Interest Rates in a DSGE Model (2018)
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Persistent link: https://EconPapers.repec.org/RePEc:svk:wpaper:1044

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