Bond Pricing with a Time‐Varying Price of Risk in an Estimated Medium‐Scale Bayesian DSGE Model

Abstract

A New-Keynesian model in which households have Epstein–-Zin preferences with time-varying risk aversion and the central bank has a time-varying in‡flation target can match the dynamics of nominal bond prices in the US economy well. The model generates a large steady-state term spread and its fitting errors for bond yields are comparable to those obtained from a non-structural three-factor model, and one third smaller than in models with a constant infl‡ation target or risk aversion. Including data on interest rates has large effects on variance decompositions, making investment technology shocks much less important than found in other recent papers.

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