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Switching Monetary Policy Regimes and the Nominal Term Structure

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  • Ferman, Marcelo

Abstract

In this paper I propose a regime-switching approach to explain why the U.S. nominal yield curve on average has been steeper since the mid-1980s than during the Great Inflation of the 1970s. I show that, once the possibility of regime switches in the short-rate process is incorporated into investors' beliefs, the average slope of the yield curve generally will contain a new component called 'level risk'. Level-risk estimates, based on a Markov-Switching VAR model of the U.S. economy, are then provided. I find that the level risk was large and negative during the Great Inflation, reflecting a possible switch to lower short-rate levels in the future. Since the mid-1980s the level risk has been moderate and positive, reflecting a small but still relevant possibility of a return to the regime of the 1970s. I replicate these results in a Markov- Switching dynamic general equilibrium model, where the monetary policy rule followed by the Fed shifts between an active and a passive regime. The model also explains why in recent decades the U.S. yield curve on average has been steeper than the yield curve in countries that adopted explicit inflation targeting frameworks.

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Bibliographic Info

Paper provided by CEPREMAP in its series Dynare Working Papers with number 5.

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Length: 66 pages
Date of creation: May 2011
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Handle: RePEc:cpm:dynare:005

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  1. Mumtaz, Haroon & Surico, Paolo, 2008. "Time-Varying Yield Curve Dynamics and Monetary Policy," Discussion Papers, Monetary Policy Committee Unit, Bank of England 23, Monetary Policy Committee Unit, Bank of England.
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  16. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
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  18. Zheng Liu & Daniel F. Waggoner & Tao Zha, 2007. "Expectation Effects of Regimes Shifts in Monetary Policy," Kiel Working Papers, Kiel Institute for the World Economy 1357, Kiel Institute for the World Economy.
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  20. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(7), pages 1425-1456, October.
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Cited by:
  1. Andreasen, Martin, 2011. "An estimated DSGE model: explaining variation in term premia," Bank of England working papers, Bank of England 441, Bank of England.

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