Essays on the term structure of interest rates, monetary policy, and business cycle

The purpose of this dissertation is to analyze the term structure of interest rates and its relation to monetary policy and the business cycle. The first chapter provides a theoretical and empirical alternative to the expectations hypothesis. The second chapter revisits the issue of why the yield spread helps predict future real economic activity.; Most empirical studies find that the expectations hypothesis does not hold, though there is little consensus about what theory should replace it. In the first chapter, I consider the possibility that liquidity plays an important role in determining the returns of various securities and focuses on banks as the principal investors and primary dealers and thus specifically models banks' liquidity. I show that liquidity plays an important role in explaining how banks determine their allocation of funds. I explore the implications of this for the term structure of interest rates and the rates of return on assets of different maturities held by banks.; I model the banks' demand for liquidity in a manner similar to that used to study household need for liquidity, namely, by using a cash-in-advance type model. In addition, the model incorporates a time-varying default risk premium. I find that the shadow price of the cash-in-advance constraint plays an important role in determining the term structure of interest rates.; The empirical part of the first chapter shows that when we do not consider the liquidity premium and default risk premium, the estimated coefficient in a regression of the change in the short-term rate on the yield spread is significantly different from zero but far from unity. After allowing for a liquidity premium and default risk premium, the estimated coefficient is close to unity. This result implies that the expectations hypothesis might be salvaged by allowing for a liquidity premium and default risk premium.; The second chapter revisits the yield spread's usefulness for predicting future real GDP growth. We shows that the contribution of the spread can be decomposed into the effect of expected future changes in short rates and the effect of the term premium. We find that both factors are relevant for predicting real GDP growth but their respective contributions differ.; We accounts for part of the contribution of the term premium using a logarithmic term structure model with a time-varying variance of the inflation forecast error. We find that the variance of inflation is a significant component of the term premium and part of the reason that the premium helps predict real GDP growth.