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Monetary Policy and the Term Structure of Interest Rates

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  • Juha Seppala
  • Federico Ravenna

Abstract

We study how well a New Keynesian business cycle model can explain the observed behavior of nominal interest rates. We focus on two puzzles raised in previous literature. First, Donaldson, Johnsen, and Mehra (1990) show that while in the U.S. nominal term structure the interest rates are pro-cyclical and term spreads counter-cyclical the stochastic growth model predicts that the interest rates are counter-cyclical and term spreads pro-cyclical. Second, according to Backus, Gregory, and Zin (1989) the standard general equilibrium asset pricing model can account for neither the sign nor the magnitude of average risk premiums in forward prices. Hence, the standard model is unable to explain rejections of the expectations hypothesis. We show that a New Keynesian model with habit-persistent preferences and a monetary policy feedback rule produces pro-cyclical interest rates, counter-cyclical term spreads, and creates enough volatility in the risk premium to account for the rejections of expectations hypothesis. Moreover, unlike Buraschi and Jiltsov (2005), we identify the systematic monetary policy, not monetary policy shocks, as the key factor behind rejections of expectations hypothesis.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2005 Meeting Papers with number 804.

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Date of creation: 2005
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Handle: RePEc:red:sed005:804

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Keywords: Term Structure of Interest Rates; Monetary Policy; Sticky Prices; Habit Formation; Expectations Hypothesis;

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References

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  1. Nakajima, Tomoyuki, 2005. "A business cycle model with variable capacity utilization and demand disturbances," European Economic Review, Elsevier, vol. 49(5), pages 1331-1360, July.
  2. Seonghoon Cho & Antonio Moreno & Geert Bekaert, 2005. "New-Keynesian Macroeconomics and the Term Structure," Faculty Working Papers 04/05, School of Economics and Business Administration, University of Navarra.
  3. Peter J. Klenow & Oleksiy Kryvtsov, 2005. "State-Dependent or Time-Dependent Pricing: Does It Matter for Recent U.S. Inflation?," Working Papers 05-4, Bank of Canada.
  4. Pau Rabanal & Juan Francisco Rubio-Ramirez, 2003. "Comparing New Keynesian models in the Euro area: a Bayesian approach," Working Paper 2003-30, Federal Reserve Bank of Atlanta.
  5. Seppala, Juha, 2004. "The term structure of real interest rates: theory and evidence from UK index-linked bonds," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1509-1549, October.
  6. Carl E. Walsh, 2003. "Monetary Theory and Policy, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262232316, December.
  7. Buraschi, Andrea & Jiltsov, Alexei, 2005. "Inflation risk premia and the expectations hypothesis," Journal of Financial Economics, Elsevier, vol. 75(2), pages 429-490, February.
  8. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
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Citations

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Cited by:
  1. Glenn D. Rudebusch & Eric T. Swanson, 2008. "Examining the bond premium puzzle with a DSGE model," Working Paper Series 2007-25, Federal Reserve Bank of San Francisco.
  2. Bianca De Paoli & Alasdair Scott & Olaf Weeken, 2006. "Asset pricing implications of a New Keynesian model," Computing in Economics and Finance 2006 358, Society for Computational Economics.
  3. Simone Casellina & Mariacristina Uberti, 2008. "Optimal Monetary Policy and Long-term Interest Rate Dynamics: Taylor Rule Extensions," Computational Economics, Society for Computational Economics, vol. 32(1), pages 183-198, September.
  4. Glenn D. Rudebusch, 2010. "Macro-Finance Models Of Interest Rates And The Economy," Manchester School, University of Manchester, vol. 78(s1), pages 25-52, 09.
  5. Renatas Kizys & Peter Spencer, 2007. "Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities," Money Macro and Finance (MMF) Research Group Conference 2006 140, Money Macro and Finance Research Group.
  6. M. Falagiarda & M. Marzo, 2012. "A DSGE model with Endogenous Term Structure," Working Papers wp830, Dipartimento Scienze Economiche, Universita' di Bologna.
  7. Taeyoung Doh, 2012. "What Does the Yield Curve Tell Us about the Federal Reserve’s Implicit Inflation Target?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44, pages 469-486, 03.
  8. Matteo Modena, 2008. "The Term Structure and the Expectations Hypothesis: a Threshold Model," Working Papers 2008_36, Business School - Economics, University of Glasgow.
  9. Shu Wu, 2008. "Monetary Policy And Long-Term Interest Rates," Contemporary Economic Policy, Western Economic Association International, vol. 26(3), pages 398-408, 07.
  10. Waters, George A., 2007. "Regime changes, learning and monetary policy," Journal of Macroeconomics, Elsevier, vol. 29(2), pages 255-282, June.
  11. Santiago Budría & Antonia Díaz, 2006. "Term and Equity Premium in Economies with Habit Formation," Working Papers 2006-23, FEDEA.
  12. Massimo Guidolin & Daniel L. Thornton, 2010. "Predictions of short-term rates and the expectations hypothesis," Working Papers 2010-013, Federal Reserve Bank of St. Louis.
  13. Santiago Budria & Antonia Diaz, 2006. "Term Premium And Equity Premium In Economies With Habit Formation," Economics Working Papers we065522, Universidad Carlos III, Departamento de Economía.
  14. Glenn D. Rudebusch & Brian P. Sack & Eric T. Swanson, 2007. "Macroeconomic implications of changes in the term premium," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 241-270.

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