Imperfect Information: The Term Structure when the Growth Rate is Unknown

This chapter serves to illustrate the effect of imperfect information on the term structure of interest rates. To isolate the informational aspect, a homogeneous economy is studied in which all agents have the same type of preferences and beliefs. The output of the economy grows at a constant rate, which is known in the case of perfect information and unknown in the case of imperfect information. In the latter case, agents engage in Bayesian inference and choose their portfolio and consumption plan on the basis of the estimated growth rate. Since there is only one Brownian motion involved, the asset market turns out to be complete under perfect, as well as under imperfect information. It is therefore possible to compare the resulting equilibrium interest rates.