Challenges in Macro-Finance Modeling
26 Pages Posted: 2 Jul 2021
Date Written: 2009
This article discusses various challenges in the specification and implementation of \\"macro-finance\\" models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. The author classifies macro-finance models into pure latent-factor models (\\"internal basis models\\") and models that have observed macroeconomic variables as state variables (\\"external basis models\\") and examines the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macroeconomic variables and their potentially adverse effect on the specification of external basis models. The author also discusses the challenge of addressing features such as structural breaks and time-varying inflation uncertainty. Empirical difficulties in the estimation and evaluation of macro-finance models are also discussed in detail.
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