Monetary Policy and the Term Spread in a Macro Model of a Small Open Economy
AbstractUsing a simple single-equation approach, many studies have shown that the term structure of interest rates or its approximation - the term spread - is a useful indicator of future inflation and/or future real economic activity. However, this paper argues that shortcomings of the single-equation approach may produce results that are biased, and that the predictive ability must be analyzed from within a model framework. We have elected to use a simple macroeconomic model of a small open economy and examine the predictive properties of the term spread from within its framework. The main contribution of this paper to the literature is threefold. First, we show that the predictive ability of the term spread is not structural but monetary-policy dependent. Second, we argue that the term spread's predictive ability with regard to future inflation (real economic activity) increases as more emphasis is placed on inflation (real economic activity) stabilization in the central bank's reaction function. Third, we show that understanding the way expectations are formed is an important prerequisite for using the term spread as an indicator. Apart from these general findings, the predictive power of the term spread is examined in the context of the Czech economy. It is shown that the term spread between one-year and three-month PRIBOR interest rates of one percentage-point indicates that agents expect inflation to be almost one percentage-point above the inflation target six quarters in the future.
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Bibliographic InfoPaper provided by Czech National Bank, Research Department in its series Working Papers with number 2002/01.
Date of creation: Oct 2002
Date of revision:
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Term spread; Monetary policy; Macroeconomic modeling;
Find related papers by JEL classification:
- E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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- TomÃ¡Å¡ Holub & JaromÃr HurnÃk, 2008. "Ten Years of Czech Inflation Targeting: Missed Targets and Anchored Expectations," Emerging Markets Finance and Trade, M.E. Sharpe, Inc., vol. 44(6), pages 67-86, November.
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