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Switching Monetary Policy Regimes and the Nominal Term Structure

  • Ferman, Marcelo

In this paper I propose a regime-switching approach to explain why the U.S. nominal yield curve on average has been steeper since the mid-1980s than during the Great Inflation of the 1970s. I show that, once the possibility of regime switches in the short-rate process is incorporated into investors' beliefs, the average slope of the yield curve generally will contain a new component called 'level risk'. Level-risk estimates, based on a Markov-Switching VAR model of the U.S. economy, are then provided. I find that the level risk was large and negative during the Great Inflation, reflecting a possible switch to lower short-rate levels in the future. Since the mid-1980s the level risk has been moderate and positive, reflecting a small but still relevant possibility of a return to the regime of the 1970s. I replicate these results in a Markov- Switching dynamic general equilibrium model, where the monetary policy rule followed by the Fed shifts between an active and a passive regime. The model also explains why in recent decades the U.S. yield curve on average has been steeper than the yield curve in countries that adopted explicit inflation targeting frameworks.

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Paper provided by CEPREMAP in its series Dynare Working Papers with number 5.

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Length: 66 pages
Date of creation: May 2011
Date of revision:
Handle: RePEc:cpm:dynare:005
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  16. Andrew Ang & Jean Boivin & Sen Dong & Rudy Loo-Kung, 2011. "Monetary Policy Shifts and the Term Structure," Review of Economic Studies, Oxford University Press, vol. 78(2), pages 429-457.
  17. Benati, Luca & Surico, Paolo, 2008. "VAR analysis and the Great Moderation," Working Paper Series 0866, European Central Bank.
  18. Eric Swanson, 2010. "Risk Aversion, the Labor Margin, and Asset Pricing in DSGE Models," 2010 Meeting Papers 138, Society for Economic Dynamics.
  19. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, Oxford University Press, vol. 121(3), pages 823-866.
  20. Taeyoung Doh & Troy Davig, 2009. "Monetary Policy Regime Shifts and Inflation Persistence," 2009 Meeting Papers 182, Society for Economic Dynamics.
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