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A joint econometric model of macroeconomic and term structure dynamics

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Author Info
Peter Hördahl () (DG Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
Oreste Tristani () (Corresponding author: DG Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
David Vestin () (DG Research, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)

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Abstract

We construct and estimate a joint model of macroeconomic and yield curve dynamics. A small-scale 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 the salient features of the term structure of interest rates and its forecasting performance is often superior to that of the best available models based on latent factors. The model has also considerable success in accounting for features of the data that represent a puzzle for the expectations hypothesis.

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Paper provided by European Central Bank in its series Working Paper Series with number 405.

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Length: 66 pages
Date of creation: Nov 2004
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Handle: RePEc:ecb:ecbwps:20040405

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Related research
Keywords: Affine term-structure models policy rules new neo-classical synthesis.

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Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation

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