Abstract:

This paper develops and quantitatively evaluates a micro-founded model of safety andliquidity premia on U.S. Treasury bonds and their relationship with unemployment.We first document empirically that both safety and liquidity premia exhibit a positivecorrelation with unemployment over the business cycle. To rationalize these findings,we propose a business-cycle framework in which both safety and liquidity premia areendogenously time-varying equilibrium outcomes. Firms issue corporate debt, whichis subject to default risk because of idiosyncratic shocks. Corporate debt also serves aliquidity role by facilitating household transactions in a decentralized product market.Households’ portfolio choices between corporate debt and government bonds optimallydepend on default risk and liquidity properties of these assets. We calibrate the modelto the U.S. economy and show that it generates empirically plausible endogenous fluc-tuations in the safety and liquidity premia in response to productivity shocks. Weargue that there are interactions between safety and liquidity components of Treasury yield spreads, and that endogenous liquidity is an important transmission mechanism.