Department of Economics and Business Economics

This paper estimates a New Keynesian model that explains key macro series, the ten-year nominal yield curve, and the ability of the spread between long- and short-term bond yields to predict future excess bond returns. The model also generates an upward sloping nominal and real yield curve, produces a positive inflation risk premium, and recovers the prediction by the expectations hypothesis of no return predictability when historical bond yields are risk-adjusted using term premia from the proposed model. Key to obtaining these results is a new specification of stochastic volatility that allows high current inflation to generate high future uncertainty.