Asset market frictions, household heterogeneity, and the liquidity theory of the term structure

We study the channels through which monetary policy influences the term premium in a general equilibrium model. The idiosyncratic liquidity demand shock and asset market participation shock generate liquidation and reinvestment risks regarding bond holdings, and the term premium can be positive or negative depending on the relative strength of the two risks. An increase in the supply of any bond increases the interest rate of all maturities; this enhances the reinvestment risk but weakens the liquidation risk. Through this "liquidity channel," a negative relationship between the interest rates and the term premium is generated, and the term premium becomes negative when the interest rates are sufficiently high. Moreover, households having different characteristics such as time discount rates and asset market participation rates demand different term premia, and this generates an endogenous market segmentation. Through this "heterogeneity channel," the large-scale asset purchases program can effectively decrease the term premium at the zero lower bound. Further, the channel is more effective when the households have a greater variance in their characteristics. (c) 2022 Elsevier Inc. All rights reserved.