Downward Nominal Rigidities and Term Premia

Abstract

We develop a macro-finance asset pricing model with downward nominal rigidities and show that it helps explain both secular and cyclical movements in term premia. The asymmetry in nominal rigidities implies that when inflation is high, nominal rigidities are less relevant, leading to larger output and inflation responses to a productivity shock. As a result, when inflation is high, the consumption-inflation covariance is more negative, making the bond premium larger. This mechanism accounts for the downward trend in the term premium since the early 1980s due to the decline of inflation. Our model also generates substantial cyclical variation in term premia (i.e. the Campbell-Shiller or Fama-Bliss predictability of bond returns), as well as other compelling macroeconomic and finance properties, such as the negative skewness of output, positive skewness of inflation, and time variation in the covariance of stock and bond returns.