Macroeconomic Implications of Term Structures of Interest Rates under Stochastic Differential Utility with Non-Unitary EIS ( Forthcoming in "Asia-Pacific Financial Markets", vol.16-3231-263, 2009; Revised in July 2009 )

Hisasi Nakamura, Wataru Nozawa and Akihiko Takahashi
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Hisasi Nakamura: Faculty of Economics, University of Tokyo
Akihiko Takahashi: Faculty of Economics, University of Tokyo

No CARF-F-141, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

Abstract: This paper proposes a continuous-time term-structure model under stochastic differential utility with non-unitary elasticity of intertemporal substitution (EIS, henceforth) in a representative-agent endowment economy with mean-reverting expectations on real output growth and inflation. Using this model, we make clear structural relationships among a term structure of real and nominal interest rates, utility form and underlying economic factors (in particular, inflation expectation). Notably, we show that, if (1) the EIS is less than one, (2) the agent is comparatively more risk-averse relative to timeseparable utility, (3) short-term interest rates are pro-cyclical, and (4) the rate of expected inflation is negatively correlated with the rate of real output growth and its expected rate, then a nominal yield curve can have a low instantaneous riskless rate and an upward slope. Keywords: Stochastic differential utility; Non-unitary EIS; Term structure of interest rates; Inflation expectation.

Pages: 44 pages
Date: 2008-11
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