David Vestin

A joint econometric model of macroeconomic and term-structure dynamics

We construct and estimate a tractable model of macroeconomic and yield curve dynamics. Bond yields are affine in the state variables of a forward-looking macromodel, and are derived assuming absence of arbitrage opportunities. Our approach allows us to interpret the dynamics of yields and risk premia in terms of macroeconomic fundamentals. In an application to German data, the forecasting performance of the model is often found to be superior to that of the best available alternatives in the affine class. Our approach has considerable success in accounting for features of the data that represent a puzzle for the expectations hypothesis.

A Joint Econometric Model of Macroeconomic and Term Structure Dynamics

We construct and estimate a joint model of macroeconomic and yield curve dynamics. A small-scale backward/forward-looking 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 salient features of the term structure of interest rates and its forecasting performance matches that of the best available models based on latent factors. The model has also considerable success in accounting for the empirical failure of the expectations hypothesis.

Inflation Expectations, Adaptive Learning and Optimal Monetary Policy

This chapter investigates the implications of adaptive learning in the private sectors formation of inflation expectations for the conduct of monetary policy. We first review the literature that studies the implications of adaptive learning processes for macroeconomic dynamics under various monetary policy rules. We then analyze optimal monetary policy in the standard New Keynesian model, when the central bank minimizes an explicit loss function and has full information about the structure of the economy, including the precise mechanism generating private sectors expectations. The focus on optimal policy allows us to investigate how and to what extent a change in the assumption of how agents form their inflation expectations affects the principles of optimal monetary policy. It also provides a benchmark to evaluate simple policy rules. We find that departures from rational expectations increase the potential for instability in the economy, strengthening the importance of anchoring inflation expectations. We also find that the simple commitment rule under rational expectations is robust when expectations are formed in line with adaptive learning.

Imperfect Knowledge and Monetary Policy: Imperfect knowledge, learning, and conservatism

Preliminary and incomplete Please do not quote without permission. Comments most welcomed.

Imperfect Knowledge and Monetary Policy: Monetary policy in uncharted territory

“If the world were clear, art would not exist.” ( albert camus, the myth of sisyphus ) Introduction This lecture focuses on the special difficulties of monetary policy making under realistic levels of uncertainty. The kind of question I have at the back of my mind is not related to the optimal setting of monetary policy within a certain model. It is connected to actual decision making and can thus be phrased as follows: how should policy be set given past dynamics and current values of available observable variables? In other words, I realistically acknowledge that, to provide a concrete example, it is not simply the case that the output gap is unobservable and difficult to measure and estimate, but also that both its definition and its role in influencing inflation dynamics are ambiguous. One problem with trying to answer directly this sort of question is that a formal treatment becomes impossible. I should therefore clarify that I do believe that mathematical models have been beneficial for economics, as they have allowed the discipline to reach results which would have been impossible to achieve without formal methods. Nevertheless, the usefulness of models should never lead us to believe that they are true representations of the world. When formal elegance becomes an end – rather than a means to an end – for theoretical research, theory risks being of little help as a guide for practical decision making.