Numerous contributions in finance have made it clear that imposing no arbitrage restrictions in empirical models of the yield curve improves their empirical characteristics (see e.g. Ang et al. 2006 for a recent example). At the same time, macroeconomic research has shown that theoretical restrictions embedded in dynamic stochastic general equilibrium (DSGE) models make current macro models competitive with VARrs (see e.g. Smets and Wouters 2007). The macro)finance literature aims to combine these two types of restrictions, in view of capturing both dimensions simultaneously, and ultimately, contribute to understanding links between the real and financial economy.
However, appending a term structure to the standard New)Keynesian model finds only limited support in the data. The response of the macro)finance literature has been to incorporate flexible features in the model. Examples are time)varying parameters (e.g. Fuhrer 1996, Favero 2006, Dewachter and Lyrio 2006) time)varying variances of structural shocks (e.g. Doh 2007b), flexible pricing kernels (e.g. Rudebusch and Wu 2007b), additional shocks (Bekaert et al. 2006), latent variables (e.g. Ang and Piazzesi 2003), etc. These additional features have brought model implied yields and observed yields closer together.
The present paper, by contrast, shows how a full fledged DSGE model receives as much empirical support, without the introduction of additional flexibility. The rationale for our approach lies in the possibility that, in current macro)finance models, the description of the macroeconomy is in some way inadequate. When present, such mis)specification will feed through to yield predictions, via the formation of expectations. We therefore focus on a more rigorously specified DSGE model in the same vein as Christiano et al. (2005) and Smets and Wouters (2007)) which, in terms of forecasting key macroeconomic aggregates, is competitive with (Bayesian) VARrs.
A more rigorous specification of the macroeconomy results in a more rigorous formation of expectations. This is a first contribution of the paper: we detail how well the rational expectations hypothesis of the term structure describes bond yield dynamics in a medium scale DSGE model. To anticipate results, we find our restrictive DSGE model to be competitive with models that do incorporate additional flexibility. In particular, we find that 90% of yield fluctuations during the past forty years are consistent with the rational expectations hypothesis. Moreover, the model is promising in terms of out of sample yield predictions.
