The New Keynesian Term Structure of Interest Rate

Title: The New Keynesian Term Structure of Interest Rate

Abstract: This paper examines the term structure of interest rates and the key drivers of the risk premium, identifying the main factors that influence the premium investors require for bearing economic risks within a micro-founded New Keynesian model featuring Calvo pricing. We address two central questions: What are the key factors shaping the term premium and the inflation risk premium, and how can fundamental economic shocks be classified as 'good' (reducing the premium) or 'bad' (increasing it)? We present a novel global solution that improves our understanding of how investors price these risks in Treasury markets. By solving the representative investor’s fundamental pricing equation and applying the Feynman-Kac formula, we compute moments of key macroeconomic variables for direct comparison with empirical data. Additionally, we connect our findings to affine term structure models and provide identifying restrictions for economic shocks in empirical work.