TY - JOUR AU - Gallmeyer,Michael F. AU - Hollifield,Burton AU - Palomino,Francisco AU - Zin,Stanley E. TI - Arbitrage-Free Bond Pricing with Dynamic Macroeconomic Models JF - National Bureau of Economic Research Working Paper Series VL - No. 13245 PY - 2007 Y2 - July 2007 UR - http://www.nber.org/papers/w13245 L1 - http://www.nber.org/papers/w13245.pdf N1 - Author contact info: Michael Gallmeyer McIntire School of Commerce University of Virginia Rouss & Robertson Halls, East Lawn P.O. Box 400173 Charlottesville, Va 22904-4173 Tel: 434-243-4043 E-Mail: mgallmeyer@virginia.edu Burton Hollifield Carnegie Mellon University Tepper School of Business 5000 Forbes Avenue Pittsburgh, PA 15213 Tel: 412-268-6505 E-Mail: burtonh@andrew.cmu.edu Francisco Palomino Department of Finance Ross School of Business University of Michigan Ann Arbor, MI 48109 E-Mail: fpal@bus.umich.edu Stanley E. Zin Department of Economics Leonard N. Stern School of Business New York University 44 West 4th Street, Suite 7-91 New York, NY 10012-1126 Tel: 212/998-0121 E-Mail: stan.zin@nyu.edu AB - We examine the relationship between monetary-policy-induced changes in short interest rates and yields on long-maturity default-free bonds. The volatility of the long end of the term structure and its relationship with monetary policy are puzzling from the perspective of simple structural macroeconomic models. We explore whether richer models of risk premiums, specifically stochastic volatility models combined with Epstein-Zin recursive utility, can account for such patterns. We study the properties of the yield curve when inflation is an exogenous process and compare this to the yield curve when inflation is endogenous and determined through an interest-rate/Taylor rule. When inflation is exogenous, it is difficult to match the shape of the historical average yield curve. Capturing its upward slope is especially difficult as the nominal pricing kernel with exogenous inflation does not exhibit any negative autocorrelation - a necessary condition for an upward sloping yield curve as shown in Backus and Zin (1994). Endogenizing inflation provides a substantially better fit of the historical yield curve as the Taylor rule provides additional flexibility in introducing negative autocorrelation into the nominal pricing kernel. Additionally, endogenous inflation provides for a flatter term structure of yield volatilities which better fits historical bond data. ER -