Term Structure of Interest Rates: Macro-Finance Approach

Paper focuses on macro-finance models that try to analyze and explain yield curve and its dynamics using macroeconomic variables as underlying factors. These models represent a growing part of financial economics having implications for both, macro and financial models. This work is an update of my monography on this topic (STORK, Zbynek. Term Structure of Interest Rates: Macro-Finance Approach. 2014). The aim of the paper is in twofold. First, it shows the possibility to come up with a consistent derivation of financial model, including yield curve using Dynamic Stochastic General Equilibrium Approach. Second, using this approach, the structural macro-finance model is able to fit real yield curve data. The paper also demonstrates that analysis of macroeconomic shocks to yield term structure should be of importance mainly for economic policy authorities that are already using DSGE models for their macro analysis. Although these institutions already work with various financial analytical tools, results of such a complex model would be consistent with macro forecasts and could serve as a benchmark. Macro-finance modelling that tries to connect these two spheres has been growing quite quickly. Attempts to derive dynamics of the yield curve usually employ Vector-Autoregression (VAR), which unfortunately do not tell much about an economic structure. In this sense, structural models are more useful and allow for better interpretability of results. The study introduces rather simple, four-equation DSGE model including blocks of households, firms, government and central bank. Solution of the macro part serves as an input to financial model. Mutual consistency is fulfilled in derivation of pricing kernel equation, which is a central point for deriving yield term structure. In this approach, it is done using macroeconomic variables and structural parameters only. Therefore, it is not necessary to rely on latent factors, as in case of VAR, that are difficult to interpret directly. Having derived such a model, it allows to estimate effects of basic macroeconomic variables such as the private and the government consumption, the short term interest rate and the inflation rate on the term structure of interest rates. Derived structural macro-finance model is able to fit an average yield curve observed in the data. Further, in case of Central Bank, simple analysis can give a notion to what extent will an economic situation have impact on different parts of yield curve and how long are these influences likely to persist. Since monetary policy is able to have an effect rather on a short end of the yield curve, it can indicate whether to respond to a particular shock or not. And possibly how costly it might be. The case of fiscal authority is for the purpose of illustration very simplified, so it is more an academic example. However, it shows an essence of the issue, i.e. that for debt management it is crucial to understand the relationship between real economy and yield term structure, since it is important for maturity distribution of the debt. Very simple calculations show how costs of debt are affected when certain economic shocks take place.