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Targeting Long-term Rates in a Model with Financial Frictions and Regime Switching

Alberto Ortiz, Sebastián Cadavid-Sánchez () and Gerardo Kattan-Rodríguez ()

Chapter 6 in Monetary Policy and Financial Stability in Latin America and the Caribbean, 2018, pp 159-219 from Centro de Estudios Monetarios Latinoamericanos, CEMLA

Abstract: Decreases (increases) in long-term interest rates caused by compressions (dilations) of term premiums could be financially expansive (contractive) and might require monetary policy restraints (stimulus). This paper uses measures of the term premium calculated by Adrian et al. (2013) to perform Bayesian estimations of a Markov-switching vector autoregression (MS-VAR) model as Hubrich and Tetlow (2015), finding evidence of the importance of allowing for switching parameters (nonlinearities) and switching variance (non-Gaussian) when analyzing macrofinancial linkages in the United States. Using the specification with the best fit to the data of two Markov states for parameters and three Markov states for variances, we estimate a Markov-switching dynamic stochastic general equilibrium (MS-DSGE) macroeconomic model with financial frictions in long-term debt instruments developed by Carlstrom et al. (2017) to provide evidence on how financial conditions have evolved in the us since 1962 and how the Federal Reserve Bank has responded to the evolution of term premiums. Using the estimated model, we perform a counterfactual analysis of the potential evolution of macroeconomic and financial variables under alternative financial conditions and monetary policy responses. We analyze six episodes with the presence of high financial frictions and/or medium and high shocks volatility. In three of them there was a high monetary policy response to financial factors: 1978Q4-1983Q4 which helped to mitigate inflation at the cost of economic activity, and the 1990Q2-1993Q4 and 2010Q1-2011Q4 episodes in which the high response served to mitigate economic contractions. Meanwhile, in the three episodes where low response to financial factors is observed, if the monetary authority had responded more aggressively, from 1971Q1-1978Q3 it could have attained lower inflation at the cost of lower GDP, from 2000Q4-2004Q4 it could have delayed the GDP contraction to 2002Q3, but this would have been deeper and inflation larger, and in 2006Q1-2009Q4 it might have precipitated the GDP contraction. The presence of high financial frictions and high shock volatility makes recessions deeper and recoveries more sluggish showing the importance of the financial-macroeconomic nexus.

Keywords: monetary policy; term-structure; financial frictions; Markov switching VAR; Markov-switching DSGE; Bayesian maximum likelihood methods. (search for similar items in EconPapers)
JEL-codes: C11 E12 E43 E44 E52 E58 (search for similar items in EconPapers)
Date: 2018
ISBN: 978-607-7734-89-5 (printed)
Note: Joint Research Program XIX Meeting of the Central Bank Researchers Network
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