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David Vestin

1 September 2003
WORKING PAPER SERIES - No. 274
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Abstract
This paper examines differences between risk-neutral and objective probability densities of future interest rates. The identification and quantification of these differences are important when risk-neutral densities (RNDs), such as option-implied RNDs, are used as indicators of actual beliefs of investors. We employ a multi-factor essentially affine modeling framework applied to German time-series and cross-section term structure data in order to identify both the risk-neutral and the objective term structure dynamics. We find important differences between risk-neutral and objective distributions due to risk premia in bond prices. Moreover, the estimated premia vary over time in a quantitatively significant way, which implies that the differences between the objective and the risk-neutral distributions also vary over time. We conclude that one should be cautious in interpreting RNDs as representing the true expectations of market participants. The method used in this paper provides an alternative approach to identifying probabilities of future interest rates.
JEL Code
G12 : Financial Economics→General Financial Markets→Asset Pricing, Trading Volume, Bond Interest Rates
E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects
7 November 2004
WORKING PAPER SERIES - No. 405
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Abstract
We construct and estimate a joint model of macroeconomic and yield curve dynamics. A small-scale rational expectations model describes the macroeconomy. Bond yields are affine functions of the state variables of the macromodel, and are derived assuming absence of arbitrage opportunities and a flexible price of risk specification. While maintaining the tractability of the affine set-up, our approach provides a way to interpret yield dynamics in terms of macroeconomic fundamentals; time-varying risk premia, in particular, are associated with the fundamental sources of risk in the economy. In an application to German data, the model is able to capture the salient features of the term structure of interest rates and its forecasting performance is often superior to that of the best available models based on latent factors. The model has also considerable success in accounting for features of the data that represent a puzzle for the expectations hypothesis.
JEL Code
E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects
E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy
E47 : Macroeconomics and Monetary Economics→Money and Interest Rates→Forecasting and Simulation: Models and Applications
Annexes
9 November 2004
ANNEX
26 June 2006
WORKING PAPER SERIES - No. 644
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Abstract
We show that, when private sector expectations are determined in line with adaptive learning, optimal policy responds persistently to cost-push shocks. The optimal response is stronger and more persistent, the higher is the initial level of perceived inflation persistence by the private sector. Such a sophisticated policy reduces inflation persistence and inflation volatility at little cost in terms of output gap volatility. Persistent responses to cost-push shocks and stability of inflation expectations resemble optimal policy under commitment and rational expectations. Nevertheless, it is clear that the mechanism at play is very different. In the case of commitment it relies on expectations of future policy actions affecting inflation expectations; in the case of sophisticated central banking it relies on the reduction in the estimated inflation persistence parameter based on inflation data generated by shocks and policy responses.
JEL Code
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy
28 June 2007
WORKING PAPER SERIES - No. 770
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Abstract
This paper compares the welfare implications of two widely used pricing assumptions in the New-Keynesian literature: Calvo-pricing vs. Rotemberg-pricing. We show that despite the strong similarities between the two assumptions to a first order of approximation, in general they might entail different welfare costs at higher order of approximation. In the special case of non-distorted steady state, the two pricing assumptions imply identical welfare losses to a second order of approximation.
JEL Code
E3 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles
E5 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit
23 October 2007
WORKING PAPER SERIES - No. 818
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Abstract
In the paper, we provide a critical and selective survey of arguments relevant for the assessment of the case for price level path stability (PLPS). Using a standard hybrid new Keynesian model we argue that price level stability provides a natural framework for monetary policy under commitment. There are two main arguments in favour of a PLPS regime. First, it helps overall macroeconomic stability by making expectations operate like automatic stabilizers. Second, under a price level path stability regime, changes in the price level operate like an intertemporal adjustment mechanism, reducing the magnitude of required changes in nominal interest rates. Such a property is particularly relevant as a means to alleviate the importance of the zero bound on nominal interest rates. We also review and discuss the arguments against price level path stability. Finally, we also found, using the Smets and Wouters (2003) model which includes a wide variety of frictions and is estimated for the euro area, that the price level is stationary under optimal policy under commitment. The results obtain when the quasi-difference of inflation is used in the loss function, as in the hybrid new Keynesian model. Overall, the arguments in favour of or against price level path stability depend on the degree of dependence of private sector expectations on the characteristics of the monetary policy regime.
JEL Code
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy
D83 : Microeconomics→Information, Knowledge, and Uncertainty→Search, Learning, Information and Knowledge, Communication, Belief
30 November 2007
WORKING PAPER SERIES - No. 832
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Abstract
We show that microfounded DSGE models with nominal rigidities can be successful in replicating features of bond yield data which have previously been considered puzzling in general equilibrium frameworks. Consistent with empirical evidence, we obtain average holding period returns that are positive, increasing in maturity and sizable, as well as long-maturity bond yields that are almost as volatile as short-term interest rates. At the same time, we are able to fit sample moments of consumption and inflation relatively well. To improve our understanding of these results, we derive analytical solutions for yields that are valid up to a second order approximation and generally applicable, We demonstrate that the improved model performance does not arise directly from the presence of nominal rigidities: ceteris paribus, the introduction of sticky-prices in a simple model tend to reduce premia. Sticky prices help indirectly because they imply (short-run) monetary non-neutrality, so that the policy rule followed by the central bank affects consumption dynamics and the pricing of yields. A very high degree of "interest rate smoothing" in the policy rule is essential for our results.
JEL Code
E43 : Macroeconomics and Monetary Economics→Money and Interest Rates→Interest Rates: Determination, Term Structure, and Effects
E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy