Stochastic Volatility in a Macro‐Finance Model of the U.S. Term Structure of Interest Rates 1961–2004

This paper generalizes the standard homoscedastic macro‐finance model by allowing for stochastic volatility, using the “square root” specification of the mainstream finance literature. Empirically, this specification dominates the standard model because it is consistent with the square root volatility found in macroeconomic time series. Thus it establishes an important connection between the stochastic volatility of the mainstream finance model and macro‐economic volatility of the Okun–Friedman type. This research opens the way to a richer specification of both macro‐economic and term structure models, incorporating the best features of both macro‐finance and mainstream finance models.