Chapter

The Economics of the Term Structure of Interest Rates

Claus Munk

in Fixed Income Modelling

Published in print June 2011 | ISBN: 9780199575084
Published online September 2011 | e-ISBN: 9780191728648 | DOI: http://dx.doi.org/10.1093/acprof:oso/9780199575084.003.0005
The Economics of the Term Structure of Interest Rates

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The issuer of a bond is borrowing money from the holder of the bond and promises to pay back the loan according to a predefined payment scheme. An individual who has a clear preference for current capital to finance investments or current consumption can borrow by issuing a bond to an individual who has a clear preference for future consumption opportunities. The price of a bond of a given maturity is, of course, set to align the demand and supply of that bond, and will consequently depend on the attractiveness of the real investment opportunities and on the individuals' preferences for consumption over the maturity of the bond. The term ‘structure of interest rates’ will reflect these dependencies. This chapter derives relations between equilibrium interest rates and aggregate consumption and production in settings with a representative agent. Examples of equilibrium term structure models that are derived from the basic relations between interest rates, consumption, and production are given. The relation between real and nominal yields is discussed. Finally, some traditional hypotheses about the shape of the term structure are critically reviewed.

Keywords: real interest rates; nominal interest rates; aggregate consumption; aggregate production; representative agent; expectation hypothesis

Chapter.  17728 words. 

Subjects: Financial Markets

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