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Working Paper

Nominal Rigidities and the Term Structures of Equity and Bond Returns

We present a production economy with nominal price rigidities that explains several asset pricing facts, including a downward-sloping term structure of the equity premium, upward sloping term structures of nominal and real interest rates, and the cyclical variation of the term structures. In the model, after a productivity shock a countercyclical labor share exacerbates the procyclicality of dividends, and hence their riskiness, and generates countercyclical inflation. The dividend share gradually increases after a negative productivity shock as the price level increases sluggishly, so the payoffs of short-duration dividend claims (bonds) are more (less) procyclical than the payoffs of long-duration claims (bonds). A slow-moving external habit then produces large and countercyclical prices for these risks as well as high risk premia at very long horizons. In bad times, the slope of equity (bond) yields for the observable maturities becomes more negative (more positive), but risk premia also increase at longer horizons, and market equity premia end up increasing by more than short-run equity premia. The simultaneous presence of market and home consumption habits allows for uniting habits and a production economy without compromising the model’s ability to fit macroeconomic variables. The central bank’s anti-inflationary stance plays a key role in shaping equity and bond prices.

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Lopez, Pierlauro, David Lopez-Salido, and Francisco Vazquez-Grande. 2023. “Nominal Rigidities and the Term Structures of Equity and Bond Returns.” Federal Reserve Bank of Cleveland, Working Paper No. 23-11.