An equilibrium model of nominal bond prices with inflation-output correlation and stochastic volatility

A vector autoregressive (VAR) model is used to describe the joint dynamics of consumption growth and inflation. The commonly used homoscedastic VAR is extended to allow for stochastic volatility, driven by an unobservable autoregressive factor. Bond prices, the conditional expectation of a function of these factors, are approximated using Tauchen's quadrature method. We show that the mean, variance, and autocorrelation of yields is captured relatively well by the VAR-SV model, calibrated with inflation and consumption data. The co-dependents of consumption and inflation are shown to be important determinants for both real and nominal rates. Time variations in inflation volatility generate realistic variability of risk premia, but unrealistically low average magnitudes. Copyright 1993 by Ohio State University Press.