What is the Real Story for Interest Rate Volatility?

25 Pages Posted: 26 Nov 2012

See all articles by Andreas Hornstein

Andreas Hornstein

Federal Reserve Bank of Richmond

Harald Uhlig

University of Chicago - Department of Economics

Date Written: October 12, 1999


What is the source of interest rate volatility? Why do low interest rates precede business cycle booms? Most observers tend to assume that monetary policy is largely responsible for it. Indeed, a standard real business cycle model delivers rather small fluctuations in real interest rates. Here, however, we present two models of the real business cycle variety in which real rate fluctuations are of similar magnitude as in the data, while simultaneously matching salient business cycle facts. The second model also replicates the cyclical behavior of real interest rates. The models build on recent work by Danthine-Donaldson, Jermann, and Boldrin-Christiano-Fisher. We assume that there are workers and capital owners. The first model posits habit formation and adjustment costs to the stock of capital. The second model assumes that it takes time to plan investment and time to build capital.

Keywords: Interest Rate Volatility, Real Business Cycle Models, Real Interest Rate, Monetary Policy, Habit Formation, Time to Plan, Time to Build, Capital Adjustment Costs

JEL Classification: E43, E44, E32, E50, G12

Suggested Citation

Hornstein, Andreas and Uhlig, Harald, What is the Real Story for Interest Rate Volatility? (October 12, 1999). FRB Richmond Working Paper No. 99-9. Available at SSRN: https://ssrn.com/abstract=2130568 or http://dx.doi.org/10.2139/ssrn.2130568

Andreas Hornstein (Contact Author)

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States
804-697-8266 (Phone)
804-697-8255 (Fax)

Harald Uhlig

University of Chicago - Department of Economics ( email )

1101 East 58th Street
Chicago, IL 60637
United States

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