Abstract: This paper documents and explores the implications of the risk price puzzle—the empirical disconnect between inflation and risk premium shocks. I show that existing New Keynesian models struggle to rationalize the risk price puzzle with an upward-sloping Phillips curve. To resolve the puzzle, I develop a novel macro-finance model that integrates a two-sector real business cycle (RBC) framework with the government debt valuation equation, which determines the price level without nominal rigidities. In the model, risk premium shocks generate the business-cycle comovement of macroeconomic quantities without implying counterfactual inflationary dynamics. Empirically, the response of inflation to risk premium shocks switches from positive to negative around 1998, mirroring the change in the stock-bond correlation. The model attributes this phenomenon to the changing covariance between shocks to the risk premium and real risk-free rate, which is consistent with both the heightened responsiveness of monetary policy to the stock market since the mid-1990s and the increasing prominence of the flight-to-safety phenomenon.

Abstract: This paper seeks to elucidate the mechanisms that generate the government debt valuation puzzle of Jiang et al. (2019) by modeling the dynamics of state-level municipal debt. Since state governments do not issue their own currencies, they are precluded from monetizing the value of their debt through inflation. Overall, there is little evidence of bubble premia in state-level debt, although deviations from the government’s intertemporal budget constraint vary by state and sample period. These findings lend credence to explanations of bubble premia arising from sizable convenience yields and/or priced peso events involving fiscal contractions.