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No-Arbitrage Taylor Rules with Switching Regimes

Author

Listed:
  • Haitao Li

    (Cheung Kong Graduate School of Business, Beijing 100738, China; and Stephen M. Ross School of Business, University of Michigan, Ann Arbor, Michigan 48109)

  • Tao Li

    (Department of Economics and Finance, City University of Hong Kong, Kowloon, Hong Kong)

  • Cindy Yu

    (Department of Statistics, Iowa State University, Ames, Iowa 50011)

Abstract

We study the time-varying nature of U.S. monetary policies summarized by the Taylor rule based on a continuous-time regime-switching term structure model. In this model, the spot rate follows the Taylor rule and government bonds at different maturities are priced by no arbitrage. We allow the coefficients of the Taylor rule and the dynamics of inflation and output gap to be regime dependent and estimate the model using government bond yields. We find that the Fed is proactive in controlling inflation in one regime and accommodative for growth in another. Moreover, proactive monetary policies are associated with more stable inflation and output gap and therefore could have contributed to the Great Moderation. Our analysis also highlights the importance of switching regimes for term structure modeling. Without the regimes, inflation and output can explain less than 50% of the variations of bond yields. With the regimes, the two variables can explain more than 80% of the variations of bond yields. This paper was accepted by Wei Xiong, finance.

Suggested Citation

  • Haitao Li & Tao Li & Cindy Yu, 2013. "No-Arbitrage Taylor Rules with Switching Regimes," Management Science, INFORMS, vol. 59(10), pages 2278-2294, October.
    • Handle: RePEc:inm:ormnsc:v:59:y:2013:i:10:p:2278-2294
    DOI: 10.1287/mnsc.1120.1702
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    References listed on IDEAS

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    2. Chung, Tsz-Kin & Iiboshi, Hirokuni, 2015. "Prediction of Term Structure with Potentially Misspecified Macro-Finance Models near the Zero Lower Bound," MPRA Paper 85709, University Library of Munich, Germany.

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