Discrete Choice Term Structure Models: Theory and Applications
50 Pages Posted: 2 Mar 2011
Date Written: October 1, 2010
The relationship between inflation, unemployment and the Federal Reserve Target rate is not linear. This is clear when the Target rate reaches its lower bound but it is also the case more generally. We introduce the class of Discrete Choice Dynamic Term Structure [DCDTS] models where the latent policy indicator and the latent threshold points are stochastic. The resulting Target rate is discrete, non-linear and can be restricted to non-negative values. Empirically, we focus on the response of the Central Bank, the responses of bond yields and that of interest rate derivatives to inflation and employment growth news. We find significant non-linearities where, in contrast with latent factors or regime-switching models, sensitivity coefficients can be interpreted directly as functions of inflation and employment. The evidence is consistent with the Fed varying the weights given to each component of its dual mandate with varying economic conditions.
Keywords: Monetary policy, Zero interest rate, Term structure of interest rates, Non-linear dynamics
JEL Classification: C13, C32, E43, E44, G12
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