Long- and Short-Term Interest Rates in a Risky World
The paper develops and tests a general equilibrium model in which variability or risk, affects the choice of portfolios. Our measures of variability include only the variability of unanticipated growth in monetary and non-monetary aggregates, and our tests use data ending with the change in Federal Reserve procedures in October 1979. We find that increased variability of unanticipated money growth raises demands for debt and money, and reduces the demand for real capital. Interest rates on both short- and long-term debt rise by a risk premium We estimate the size of the risk premium before and after the October 1979 change, and we show that the change in Federal Reserve procedures moved the economy to a less efficient point.