The Yield Curve and Macroeconomic Dynamics

66 Pages Posted: 6 Dec 2007

See all articles by Peter Hördahl

Peter Hördahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific

Oreste Tristani

European Central Bank (ECB)

David Vestin

European Central Bank (ECB)

Date Written: November 2007

Abstract

We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data which have previously been considered puzzling in general equilibrium frameworks. Consistent with empirical evidence, we obtain average holding period returns that are positive, increasing in maturity and sizable, as well as long-maturity bond yields that are almost as volatile as short-term interest rates. At the same time, we are able to fit sample moments of consumption and inflation relatively well. To improve our understanding of these results, we derive analytical solutions for yields that are valid up to a second order approximation and generally applicable, We demonstrate that the improved model performance does not arise directly from the presence of nominal rigidities: ceteris paribus, the introduction of sticky-prices in a simple model tend to reduce premia. Sticky prices help indirectly because they imply (short-run) monetary non-neutrality, so that the policy rule followed by the central bank affects consumption dynamics and the pricing of yields. A very high degree of 'interest rate smoothing' in the policy rule is essential for our results.

Keywords: DSGE models, policy rules, term structure of interest rates, risk premia, second order approximations.

JEL Classification: E43, E44

Suggested Citation

Hoerdahl, Peter and Tristani, Oreste and Vestin, David, The Yield Curve and Macroeconomic Dynamics (November 2007). ECB Working Paper No. 832, Available at SSRN: https://ssrn.com/abstract=1030206 or http://dx.doi.org/10.2139/ssrn.1030206

Peter Hoerdahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific ( email )

78th floor, Two International Finance Centre
8 Finance Street, Central
Hong Kong

Oreste Tristani (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
0049 69 13440 (Phone)
0049 69 1344 6000 (Fax)

David Vestin

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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