How does the Bond Market Perceive Government Interventions?
The investor believes in Ricardian equivalence but fears that it might not hold in reality. The investor is exposed to two types of government uncertainties. First, uncertainty about whether Ricardian equivalence holds. Second, uncertainty about the expected effectiveness of government interventions. The investor requests in equilibrium time-varying uncertainty premiums for both types of policy uncertainty. These endogenous uncertainty premiums make the real and nominal yield curve slope upwards and explain 74% of variations in the Cochrane and Piazzesi bond premium factor. These government intervention premiums predict annual bonds returns with an R^2 of up to 25%.
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