Real and Nominal Interest Rates: A Discrete-Time Model and Its Continuous- Time Limit

I provide a general equilibrium theory of the term structure of real interest rates in a discrete-time economy. I derive the prices for one-period and two-period real bonds and a simple recursive formula for general k-period bonds, and prove that the price formula with appropriately specified parame...

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Bibliographic Details
Published in:The Review of financial studies 1992-01, Vol.5 (4), p.581-611
Main Author: Sun, Tong-sheng
Format: Article
Language:English
Subjects:
Arbitrage
Bond market
Consumer Price Index
Consumption
Discounts
Economic growth rate
Economic modeling
Economic models
Endowment
Endowments
Equilibrium
Financial bonds
Financial economics
Growth rate
Hypotheses
Inflation rates
Interest rates
Nominal interest rates
Price levels
Risk premiums
Utility functions
Yield to maturity
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Summary:I provide a general equilibrium theory of the term structure of real interest rates in a discrete-time economy. I derive the prices for one-period and two-period real bonds and a simple recursive formula for general k-period bonds, and prove that the price formula with appropriately specified parameters converges to that of the Cox, Ingersoll, and Ross model (1985). In addition, I consider the behavior of nominal bond prices in a partial equilibrium setting in which an exogenous price level process is correlated with the real economy. Finally, I provide an illustrative empirical investigation of the model. The results indicate a significant correlation between the price level and the growth rate of consumption, which does not support the "money neutrality" assumption underlying Cox, Ingersoll, and Ross's nominal bond prices and related empirical studies, such as Gibbons and Ramaswamy (1992), Heston (1991), and Pearson and Sun (1991).
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/5.4.581