THE TERM STRUCTURE OF INTEREST-RATES OVER THE BUSINESS-CYCLE

Whether real GNP is assumed to be trend-stationary or difference-stationary, which implies that shocks have transitory or permanent effects, is critically important in explaining the behavior of the forward risk premium, the term risk premium, and changes in the yield curve over the business cycle. While this is the main result, there are two additional results of interest. First, although movements in the nominal yield spread are useful in predicting future economic activity, these movements are not enough to separate real from nominal shocks. The source of the shock can be determined if movements in the spread and shifts in the nominal yield curve are used jointly. Second, the yield differential, which is defined as the difference between the yields on inflation-indexed bonds and nominal bonds, is generally a biased predictor of expected inflation and may signal the wrong information about changes in expected inflation.