Market Risk Premium
... terest rates. We consider a general equilibrium production economy in which (i) the monetary policy is responsive to both nominal and real shocks, (ii) the stochastic process for in°ation is endogenous, (iii) taxes are paid on nominal pro¯ts and the ¯scal system is allowed to be only partially indexed to in°ation shocks. The distortionary impact of in°ation generates the potential existence of a risk premium on the in°ation rate. (iv) In addition to nominal shocks, the stochastic investment opportunity set is a®ected by multiple real factors. We obtain analytical solutions for the equilibrium term structure of nominal and real interest rates. Moreover, we compute closed-form solutions for the risk premium on the in°ation rate. In the econometric section, we estimate the monetary model using a dataset on all US Treasury bonds traded between 1960 to 1996. We estimate the risk premium on the in°ation rate and formally test the Fisher hypothesis. Second, we discuss a speci¯cation test for the number of factors in the monetary term structure model that explicitly addresses the well known stochastic singularity problem that a®ects likelihood-based test when applied to state-space models. Moreover, we measure the extent of time variation of risk premia on nominal (monetary) shocks with respect to real (technological) shocks. The results shed some light on whether the rejection of the expectation hypothesis is due mainly to the time variation of the risk premium on nominal shocks, the risk premium on the real factors or both. terest rates. We consider a general equilibrium production economy in which (i) the monetary policy is responsive to both nominal and real shocks, (ii) the stochastic process for in°ation is endogenous, (iii) taxes are paid on nominal pro¯ts and the ¯scal system is allowed to be only partially indexed to in°ation shocks. The distortionary impact of in°ation generates the potential existence of a risk premium on the in°ation rate. (iv) In addition to nominal shocks, the stochastic investment opportunity set is a®ected by multiple real factors. We obtain analytical solutions for the equilibrium term structure of nominal and real interest rates. Moreover, we compute closed-form solutions for the risk premium on the in°ation rate. In the econometric section, we estimate the monetary model using a dataset on all US Treasury bonds traded between 1960 to 1996. We estimate the risk premium on the in°ation rate and formally test the Fisher hypothesis. Second, we discuss a speci¯cation test for the number of factors in the monetary term structure model that explicitly addresses the well known stochastic singularity problem that a®ects likelihood-based test when applied to state-space models. Moreover, we measure the extent of time variation of risk premia on nominal (monetary) shocks with respect to real (technological) shocks. The results shed some light on whether the rejection of the expectation hypothesis is due mainly to the time variation of the risk premium on nominal shocks, the risk premium on the real factors or both...