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

Indrajit Mitra and Yu Xu

The Review of Financial Studies, 2024, vol. 37, issue 8, 2461-2509

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.

JEL-codes: E24 E43 E44 G12 J64 (search for similar items in EconPapers)
Date: 2024
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