Monetary Policy Regimes: Implications for the Yield Curve and Bond Pricing
58 Pages Posted: 14 Mar 2013 Last revised: 8 Oct 2013
Date Written: October 7, 2013
Abstract
We develop a multivariate dynamic term structure model, which takes into account the nonlinear (time-varying) relationship between interest rates and the state of the economy. In contrast to the classical term structure literature, where nonlinearities are captured by increasing the number of latent state variables, or by latent regime shifts, in our no-arbitrage framework the regimes are governed by thresholds and are directly linked to economic fundamentals. Specifically, starting from a simple monetary policy model for the short rate, we introduce a parsimonious and tractable model for the yield curve, which takes into account the possibility of regime shifts in the behavior of the Federal Reserve. In our empirical analysis, we show the merit of our approach along the following dimensions: (i) interpretable bond dynamics; (ii) accurate short end yield curve pricing; (iii) yield curve implications.
Keywords: Threshold regime switching model; Macroeconomic variables; Term structure of interest rates; Asset pricing; Nonlinear dynamics; Business cycles.
JEL Classification: C32, C51, C52, C53, E43, G12
Suggested Citation: Suggested Citation
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