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Abstract

In standard bond pricing macroeconomic models, the weights of expected inflation errors are too high in the nominal yields forecast error variance decomposition. This paper tries to solve the problem by incorporating preference shocks and liquidity shocks into a bond pricing New Keynesian model. This paper documents that the incorporation of preference shocks offers negligible improvements, and the incorporation of liquidity shocks could decrease the weights of expected inflation forecast errors at short maturities, but still offer no improvements at long maturities. Furthermore, this paper provides an optional method to model a liquidity provider and financial intermediaries in a bond pricing New Keynesian model.

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