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The impact of monetary policy on bond returns: A segmented markets approach

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Listed author(s):
  • Mizrach, Bruce
  • Occhino, Filippo

Abstract

This paper assesses the contribution of monetary policy to the dynamics of bond real returns. We assume that the monetary authority controls the short-term nominal interest rate. We then model exogenously the joint dynamics of the aggregate endowment and the monetary policy variable, and determine bond real returns endogenously. Market segmentation is introduced by permanently excluding a fraction of households from financial markets. When markets are segmented, monetary policy has a liquidity effect on the participants' consumption and marginal utility, on the stochastic discount factor, and on real returns. Data on bond returns strongly favor the segmented markets model over the full participation model. For maturities up to 2 years, the segmented markets model is able to replicate the sign and the size of the impulse response of bond returns to monetary policy shocks, it correctly predicts the sign of their autocorrelation, and it closely matches their volatility as a function of maturity.

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File URL: http://www.sciencedirect.com/science/article/pii/S0148-6195(07)00048-3
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Article provided by Elsevier in its journal Journal of Economics and Business.

Volume (Year): 60 (2008)
Issue (Month): 6 ()
Pages: 485-501

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Handle: RePEc:eee:jebusi:v:60:y:2008:i:6:p:485-501
Contact details of provider: Web page: http://www.elsevier.com/locate/jeconbus

Keywords: Bond returns volatility Limited participation Segmented markets Monetary policy shocks;

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  1. Lahiri, Amartya & Singh, Rajesh & Vegh, Carlos, 2007. "Segmented asset markets and optimal exchange rate regimes," Journal of International Economics, Elsevier, vol. 72(1), pages 1-21, May.
  2. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
  3. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  4. Christopher A. Sims & Tao Zha, 1999. "Error Bands for Impulse Responses," Econometrica, Econometric Society, vol. 67(5), pages 1113-1156, September.
  5. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-144, January.
  6. Fernando Alvarez & Robert E. Lucas & Warren E. Weber, 2001. "Interest Rates and Inflation," American Economic Review, American Economic Association, vol. 91(2), pages 219-225, May.
  7. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  8. John Landon-Lane & Filippo Occhino, 2004. "A Likelihood-Based Evaluation of the Segmented Markets Friction in Equilibrium Monetary Models," Departmental Working Papers 200415, Rutgers University, Department of Economics.
  9. Filippo Occhino, 2004. "Modeling the Response of Money and Interest Rates to Monetary Policy Shocks: A Segmented Markets Approach," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(1), pages 181-197, January.
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Cited by:

  1. Zervou, Anastasia S., 2013. "Financial market segmentation, stock market volatility and the role of monetary policy," European Economic Review, Elsevier, vol. 63(C), pages 256-272.
  2. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.

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