Equilibrium Growth, Inflation, and Bond Yields - Duke University's ...

nominal yield curve and sizeable term spread. 29
I first begin with a discussion of the equilibrium inflation and growth dynamics. Note that in the
bottom row of Figure 1 the benchmark model (ENDO 1) replicates the negative low-frequency patterns in
consumption growth and inflation from the data. As before, the low-frequency component is identified using
a bandpass filter, where the bandwidth is from 32 to 200 quarters. Indeed, Table 10 shows that the ENDO 1
closely matches low-frequency correlations between macro growth rates and inflation. Furthermore, expected
consumption growth and expected inflation are strongly negatively correlated. To understand the mechanics
behind these endogenous long-run dynamics, it is instructive to look at the impulse response functions from
Figure 6. First, I will focus on the IRFs for ENDO 1 which correspond to the solid lines. When a good
productivity shock is realized, expected growth rates, including consumption growth, increase persistently
as discussed above. Now, I will also show that expected inflation declines persistently in response to a good
productivity shock. Recall from Section 3, inflation depends on positively on the wage to capital ratio and
labor hours worked, and negatively on the productivity shock and the R&D stock to physical capital stock
ratio:
where γ1 = ν−1
φR > 0, γ2 = β∆Y
�πt = γ1 �mct + γ2Et[�πt+1]
�mct = �wt + α � lt − (1 − α)�at − (1 − α)�nt
1 1− ψ
ss
> 0, and lowercase tilde variables denote log deviations from the steady-
state. As discussed above, �wt and � lt increase in response to an increase in �at. In addition, because the firm
has very high incentives to take advantage of the good shock to increase long-run growth prospects, the stock
of R&D increases more relative to the increase in physical capital. Thus, �nt also increases. Quantitatively,
the increase in the terms (1 − α)�at and (1 − α)�nt dominates the increase in �wt and α � lt, so that marginal
costs, and therefore inflation declines. In sum, the productivity shock drives a strong negative relationship
between expected consumption growth and expected inflation. Moreover, these dynamics are reflected in
asset markets by an upward sloping yield curve and sizeable term spread.
Importantly, there is strong empirical support for these model-implied inflation-growth dynamics. Barsky
and Sims (2010) and Kurmann and Otrok (2011) show in a VAR that a positive shock to expected produc-
tivity growth (“news shock”) leads to large and persistent decline in inflation. In the benchmark growth
model, fluctuations to expected productivity growth are driven by R&D rates. Specifically, in the bench-
mark growth model, the expected productivity growth component is the growth rate of the stock of R&D.
As discussed above, a persistent increase in R&D during good times lowers marginal costs and inflation per-
29 Piazzesi and Schneider (2006) and Bansal and Shaliastovich (2010) highlight this point in endowment economy
setups where inflation and consumption growth are exogenously specified and assumed to be negatively correlated.
Furthermore, they find strong empirical evidence for this negative relationship.
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