No-Arbitrage Taylor Rules with Switching Regimes

39 Pages Posted: 12 Jan 2011 Last revised: 17 Sep 2012

See all articles by Haitao Li

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Tao Li

City University of Hong Kong (CityUHK) - Department of Economics & Finance

Cindy Yu

Iowa State University

Multiple version iconThere are 2 versions of this paper

Date Written: May 2012

Abstract

We study the time-varying nature of US monetary policies summarized by the Taylor rule based on a continuous-time regime-switching term structure model. In this model, the spot rate follows the Taylor rule and government bonds at different maturities are priced by no-arbitrage. We allow the coefficients of the Taylor rule and the dynamics of inflation and output gap to be regime-dependent and estimate the model using government bond yields. We find that the Fed is proactive in controlling inflation in one regime and is accommodative for growth in another. Moreover, proactive monetary policies are associated with more stable inflation and output gap and therefore could have contributed to the "Great Moderation." Our analysis also highlights the importance of switching regimes for term structure modeling. Without the regimes, inflation and output can explain less than 50\% of the variations of bond yields. With the regimes, the two variables can explain more than 80\% of the variations of bond yields.

Keywords: Taylor rule, Term structure, Regime-switching, MCMC

JEL Classification: C11, E43, G11

Suggested Citation

Li, Haitao and Li, Tao and Yu, Cindy, No-Arbitrage Taylor Rules with Switching Regimes (May 2012). Available at SSRN: https://ssrn.com/abstract=1738805 or http://dx.doi.org/10.2139/ssrn.1738805

Haitao Li

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Tao Li (Contact Author)

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Cindy Yu

Iowa State University ( email )

613 Wallace Road
Ames, IA 50011
United States

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