Discrete Choice Term Structure Models: Theory and Applications

50 Pages Posted: 2 Mar 2011  

Bruno Feunou

Bank of Canada

Jean-Sebastien Fontaine

Bank of Canada

Date Written: October 1, 2010

Abstract

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

Suggested Citation

Feunou, Bruno and Fontaine, Jean-Sebastien, Discrete Choice Term Structure Models: Theory and Applications (October 1, 2010). Available at SSRN: https://ssrn.com/abstract=1772971 or http://dx.doi.org/10.2139/ssrn.1772971

Bruno Feunou (Contact Author)

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Jean-Sebastien Fontaine

Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

HOME PAGE: http://www.jean-sebastienfontaine.com

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