Essays on bond pricing and growth-indexed bonds within the new Keynesian framework

The term structure of interest rate has long been a special topic of interest in both academia and the financial market. A plethora of models developed in both finance and macroeconomics literature are only partially useful for either macroeconomic analysis or bond pricing, but not for both at the same time. The second chapter of this thesis focuses on this issue from the macroeconomic viewpoints. Firstly, we survey the important papers in term structure of interest rates and asset pricing models and discuss their key features. We then examine the ability of standard DSGE models at replicating the stylized bond pricing facts especially focusing on the volatility of long-term bonds. Lastly, we survey various recent modifications made to the DSGE models and investigate whether and how each approach may (or may not) improve the ability of DSGE model in terms of replicating key bond pricing facts, either under the expectations hypothesis or with the help of term premium.

The third chapter focuses on nominal GDP growth-indexed bonds where their nominal payoffs are fully indexed to nominal GDP growth of the issuing country. The idea of indexing government debt to a country's growth rate goes back at least to the 1980s, and several papers have already illustrated the potential benefits of issuing such bonds. However, most of the analysis were conducted using partial equilibrium models. In addition, as there exists no actual market for such an asset, only few analyses exist for the price of growth-indexed bonds, and most of them are based on simple CAPM models.In this chapter, on the contrary, we try to calculate the theoretical price of nominal GDP growth-indexed bonds using a general equilibrium model. Based on a medium sized New Keynesian DSGE model estimated with the U.S. macroeconomic data, we show that the government may face lower borrowing cost when replacing conventional nominal bonds with nominal GDP growth-indexed bonds, assuming the other premiums - such as novelty and liquidity premiums - are negligible. As a by-product of the analysis, we also show such a change may benefit the government by giving more room for countercyclical fiscal policy.

The fourth chapter examines the welfare effect of growth-indexed bonds within the framework of new Keynesian DSGE model. Even though there already exist papers that show issuing growth-indexed bond may help stabilize the debt process and give more room for countercyclical fiscal policy, the analysis on its welfare effect has not been actively conducted, especially within the framework of general equilibrium model. It was mostly because the standard

DSGE models, where Ricardian equivalence holds, the choices of consumers are immune to the source of government finance. This chapter examines whether and how the use of growth-indexed bonds, instead of the conventional nominal bonds, affects the business cycle and welfare when Ricardian equivalence does not hold any more. More specifically, we augmented hand to mouth households, distortionary income taxes, and Epstein-Zin type recursive preference to the most widely used medium scale DSGE model of Smets and Wouters (2007). The results show that the growth-indexed bond can significantly increase the welfare of the hand-to-mouth households by stabilising their consumption and labour especially when the government cannot flexibly change its debt-to-GDP ratio.