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The Canadian macroeconomy and the yield curve: an equilibrium-based approach

  • René Garcia
  • Richard Luger

The authors develop and estimate an equilibrium-based model of the Canadian term structure of interest rates. The proposed model incorporates a vector-autoregression description of key macroeconomic dynamics and links them to those of the term structure, where identifying restrictions are based on the first-order conditions that describe the representative investor's optimal consumption and portfolio plan. A remarkable result is that the in-sample average pricing errors obtained with the equilibrium-based model are only slightly larger than those obtained with a far more flexible no-arbitrage model. The gains associated with parsimony become obvious out-of-sample, where the equilibrium model delivers much more accurate predictions, especially for yields with longer-term maturities. The preferred equilibrium model has impulse responses that are consistent with long-term inflation expectations being anchored, so a surprise increase in inflation does not necessarily raise expectations of higher future inflation.

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Article provided by Canadian Economics Association in its journal Canadian Journal of Economics.

Volume (Year): 40 (2007)
Issue (Month): 2 (May)
Pages: 561-583

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Handle: RePEc:cje:issued:v:40:y:2007:i:2:p:561-583
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