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Monetary policy, expected inflation and inflation risk premia

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  • Ravenna , Federico

    ()
    (University of California, Department of Economics.)

  • Seppälä, Juha

    ()
    (University of Illinois, Department of Economics)

Abstract

Within a New Keynesian business cycle model, we study variables that are normally unobservable but are very important for the conduct of monetary policy, namely expected inflation and inflation risk premia. We solve the model using a third-order approximation that allows us to study time-varying risk premia. Our model is consistent with rejection of the expectations hypothesis and the business-cycle behaviour of nominal interest rates in US data. We find that inflation risk premia are very small and display little volatility. Hence, monetary policy authorities can use the difference between nominal and real interest rates from index-linked bonds as a proxy for inflation expectations. Moreover, for short maturities current inflation is a good predictor of inflation risk premia. We also find that short-term real interest rates and expected inflation are significantly negatively correlated and that short-term real interest rates display greater volatility than expected inflation. These results are consistent with empirical studies that use survey data and index-linked bonds to obtain measures of expected inflation and real interest rates. Finally, we show that our economy is consistent with the Mundell-Tobin effect: increases in inflation are associated with higher nominal interest rates, but lower real interest rates.

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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 18/2007.

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Length: 33 pages
Date of creation: 11 Oct 2007
Date of revision:
Handle: RePEc:hhs:bofrdp:2007_018

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: term structure of interest rates; monetary policy; expected inflation; inflation risk premia; Mundell-Tobin effect;

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References

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Citations

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Cited by:
  1. Paolo Zagaglia, 2011. "Forecasting Long-Term Interest Rates with a Dynamic General Equilibrium Model of the Euro Area: The Role of the Feedback," Working Paper Series 19_11, The Rimini Centre for Economic Analysis.
  2. Zagaglia, Paolo, 2009. "Forecasting with a DSGE Model of the term Structure of Interest Rates: The Role of the Feedback," Research Papers in Economics 2009:14, Stockholm University, Department of Economics.
  3. Mehmet Pasaogullari & Simeon Tsonevy, 2011. "The term structure of inflation compensation in the nominal yield curve," Working Paper 1133, Federal Reserve Bank of Cleveland.
  4. Oreste Tristani & Gianni Amisano, 2010. "A nonlinear DSGE model of the term structure with regime shifts," 2010 Meeting Papers 234, Society for Economic Dynamics.

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