Ebook New-Keynesian Macroeconomics and the Term Structure
Structural New-Keynesian models, featuring dynamic aggregate supply (AS), aggregate demand (IS) and monetary policy equations are becoming pervasive in macroeconomic analysis. In this article we complement this structural macroeconomic framework with a no-arbitrage term structure model.
Our analysis overcomes three deficiencies in previous work on New-Keynesian macro models. First, the parsimony of such models implies very limited information sets for both the monetary authority and the private sector. It is well known, however, that monetary policy is conducted in a data-rich environment. Recent research by Bernanke and Boivin (2003) and Bernanke, Boivin, and Eliasz (2005) collapses multiple observable time series into a small number of factors and embeds them in standard vector autorregresive (VAR) analyses. In this article we use perhaps the most efficient information of all, term structure data.
The critical variables in most macro models are the output gap, expected inflation and a short-term interest rate. It is unlikely that lags of inflation, the output gap and the short-term interest rate suffice to adequately forecast their future behavior. However, under the null of the Expectations Hypothesis, term spreads embed all relevant information about future interest rates. Additionally, a host of studies have shown that term spreads are very good predictors of future economic activity (see, for instance, Harvey (1988), Estrella and Mishkin (1998), Ang, Piazzesi, and Wei (2004)) and of future inflation (Mishkin (1990) or Stock and Watson (2003)). In our proposed model, the conditional expectations of inflation and the detrended output are a function of the past realizations of macro variables and of unobserved components which are extracted from term structure data through a no-arbitrage pricing model.
Second, the additional information from the term structure model transforms a version of a New-Keynesian model with a number of unobservable variables into a very tractable linear model which can be efficiently estimated by maximum likelihood or the general method of moments (GMM). Hence, the term structure information helps recover important structural parameters, such as those describing the monetary transmission mechanism, in an econometrically efficient manner.
Third, incorporating term structure information leads to a simple VAR on macro variables and term spread information but the reduced-form model for the macro variables is a complex VARMA model. This is important because one disadvantage of most structural New-Keynesian models is the absence of sufficient endogenous persistence. We generate additional channels of endogenous persistence by introducing unobservable variables in the macro model which must be identified from the term structure.
The approach set forth in this paper also contributes to the term structure literature. In this literature it is common to have latent factors drive most of the dynamics of the term structure of interest rates. These factors are often interpreted ex-post as level, slope and curvature factors. A classic example of this approach is Dai and Singleton (2000), who construct an arbitrage-free three factor model of the term structure. While the Dai and Singleton (2000) model provides a satisfactory fit of the data, it remains silent about the economic forces behind the latent factors. In contrast, we construct a no-arbitrage term structure model where all the factors have a clear economic meaning. Apart from inflation, detrended output and the short term interest rate, we introduce two unobservable variables in the underlying macro model. While there are many possible implementations, our main application here introduces a time-varying inflation target and the natural rate of output. Consequently, we construct a 5 factor affine term structure model that obeys New-Keynesian structural relations.
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