No-Arbitrage Taylor Rules
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Columbia Business School - Economics Department
University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)
November 15, 2004
We estimate Taylor (1993) rules and identify monetary policy shocks using no-arbitrage pricing techniques. Long-term interest rates are risk-adjusted expected values of future short rates and thus provide strong over-identifying restrictions about the policy rule used by the Federal Reserve. We find that inflation and GDP growth account for over half of the timevariation of yield levels and we attribute almost all of the movements in the term spread to inflation. We find that Taylor rules estimated with no-arbitrage restrictions differ substantially from Taylor rules estimated by OLS and monetary policy shocks identified with no-arbitrage techniques are less volatile than their OLS counterparts. The no-arbitrage framework also accommodates backward-looking and forward-looking Taylor rules.
Number of Pages in PDF File: 56
Keywords: Affine term structure model, monetary policy, interest rate risk
JEL Classification: C13, E43, E52, G12working papers series
Date posted: November 21, 2004
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