Estimating Diffusion Models of Interest Rates at the Zero Lower Bound: From the Great Depression to the Great Recession and Beyond

Lealand Morin

A chapter in Essays in Honor of Joon Y. Park: Econometric Methodology in Empirical Applications, 2023, vol. 45B, pp 159-179 from Emerald Group Publishing Limited

Abstract: The time series of the federal funds rate has recently been extended back to 1928, now including several episodes during which interest rates remained near the lower bound of zero. This series is analyzed, using the method of indirect inference, by applying recent research on bounded time series to estimate a set of bounded parametric diffusion models. This combination uncouples the specification of the bounds from the law of motion. Although Louis Bachelier was the first to use arithmetic Brownian motion to model financial time series, he has often been criticized for this proposal, since the process can take on negative values. Most researchers favor processes such as geometric Brownian motion (GBM), which remains positive. Under this framework, Bachelier's proposal remains valid when specified with bounds and is shown to compare favorably when modeling the federal funds rate.

Keywords: Federal funds target rate; interest rate; zero lower bound; diffusion processes; regulated Brownian motion; bounded processes (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eme:aecozz:s0731-90532023000045b006

DOI: 10.1108/S0731-90532023000045B006

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