A Joint Econometric Model of Macroeconomic and Term Structure Dynamics
52 Pages Posted: 23 Jul 2003
Date Written: November 7, 2003
We construct and estimate a joint model of macroeconomic and yield curve dynamics. A small-scale backward/forward-looking rational expectations model describes the macroeconomy. Bond yields are affine functions of the state variables of the macromodel, and are derived assuming absence of arbitrage opportunities and a flexible price of risk specification. While maintaining the tractability of the affine set-up, our approach provides a way to interpret yield dynamics in terms of macroeconomic fundamentals; time-varying risk premia, in particular, are associated with the fundamental sources of risk in the economy. In an application to German data, the model is able to capture salient features of the term structure of interest rates and its forecasting performance matches that of the best available models based on latent factors. The model has also considerable success in accounting for the empirical failure of the expectations hypothesis.
Keywords: affine term-structure models, policy rules, new neo-classical synthesis
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