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Why Does the Yield Curve Predict Economic Activity? Dissecting the Evidence for Germany and the United States

Frank Smets and Kostas Tsatsaronis ()

No 1758, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper investigates why the slope of the yield curve predicts future economic activity in Germany and the United States. A structural VAR is used to identify aggregate supply, aggregate demand, monetary policy and inflation scare shocks and to analyse their effects on the real, nominal and term premium components of the term spread and on output. In both countries demand and monetary policy shocks contribute to the covariance between output growth and the lagged term spread, while inflation scares do not. As the latter are more important in the United States, they reduce the predictive content of the term spread in that country. However, the main reason for the stronger leading indicator property in Germany is the positive contribution of supply shocks, which owing to a different monetary policy response explains about half of the positive covariance at lag four in Germany and almost nothing in the United States.

Keywords: Germany; Information Content; Monetary Policy; Term Structure of Interest Rates; United States (search for similar items in EconPapers)
JEL-codes: E43 E44 E58 (search for similar items in EconPapers)
Date: 1997-12
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