Term Premium Dynamics and the Taylor Rule

Abstract

We explore the bond-pricing implications of an exchange economy where preference shocks result in time-varying term premiums in real yields with a Taylor rule determining inflation dynamics and nominal term premiums. We calibrate the model by matching the term structure of the means and volatilities of nominal yields. Unlike a model with exogenous inflation, a Taylor rule matching empirical properties of inflation leads to nominal term premiums that are volatile at long maturities. Increasing monetary policy aggressiveness decreases the level and volatility of nominal yields.