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The Canadian Macroeconomy and the Yield Curve: An Equilibrium-Based Approach

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The authors develop and estimate an equilibrium-based model of the Canadian term structure of interest rates. The proposed model incorporates a vector-autoregression description of key macroeconomic dynamics and links them to those of the term structure, where identifying restrictions are based on the first-order conditions that describe the representative investor's optimal consumption and portfolio plan. A remarkable result is that the in-sample average pricing errors obtained with the equilibrium-based model are only slightly larger than those obtained with a far more flexible no-arbitrage model. The gains associated with parsimony become obvious out-of-sample, where the equilibrium model delivers much more accurate predictions, especially for yields with longer-term maturities. The preferred equilibrium model has impulse responses that are consistent with long-term inflation expectations being anchored, so a surprise increase in inflation does not necessarily raise expectations of higher future inflation.

Published In:

Canadian Journal of Economics (0008-4085)
May 2007. Vol. 40, Iss. 2; p. 561-83

Topic(s): Interest rates
JEL Code(s): E, E4, E43, E44, E47, E5, E52