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Challenges in macro-finance modeling

  • Don H Kim
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    This paper discusses various challenges in the specification and implementation of "macro-finance" models in which macroeconomic variables and term structure variables are modeled together in a no-arbitrage framework. I classify macro-finance models into pure latent-factor models ("internal basis models") and models which have observed macroeconomic variables as state variables ("external basis models"), and examine the underlying assumptions behind these models. Particular attention is paid to the issue of unspanned short-run fluctuations in macro variables and their potentially adverse effect on the specification of external basis models. I also discuss the challenge of addressing features like structural breaks and time-varying inflation uncertainty. Empirical difficulties in the estimation and evaluation of macro-finance models are also discussed in detail.

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    Paper provided by Bank for International Settlements in its series BIS Working Papers with number 240.

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    Length: 44 pages
    Date of creation: Dec 2007
    Date of revision:
    Handle: RePEc:bis:biswps:240
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    1. Andrew Ang & Sen Dong, 2005. "No-Arbitrage Taylor Rules," 2005 Meeting Papers 22, Society for Economic Dynamics.
    2. Hordahl, Peter & Tristani, Oreste & Vestin, David, 2006. "A joint econometric model of macroeconomic and term-structure dynamics," Journal of Econometrics, Elsevier, vol. 131(1-2), pages 405-444.
    3. Andrew Ang & Geert Bekaert & Min Wei, 2005. "Do Macro Variables, Asset Markets or Surveys Forecast Inflation Better?," NBER Working Papers 11538, National Bureau of Economic Research, Inc.
    4. Michael J. Fleming & Eli M. Remolona, 1997. "What moves the bond market?," Research Paper 9706, Federal Reserve Bank of New York.
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