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Volatility-Induced Stationarity and Error-Correction in Macro-Finance Term Structure Modeling

Anne Lundgaar Hansen
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Anne Lundgaar Hansen: Department of Economics, University of Copenhagen, Denmark

No 18-12, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: It is well-known that interest rates and inflation rates are extremely persistent, yet they are best modeled and understood as stationary processes. These properties are contradictory in the workhorse Gaussian affine term structure model in which the persistent data often result in unit roots that imply non-stationarity. We resolve this puzzle by proposing a macro-finance term structure model with volatility-induced stationarity. Our model employs a level-dependent conditional volatility that maintains stationarity despite presence of unit roots in the characteristic polynomial corresponding to the conditional mean. Compared to the Gaussian affine term structure model, we improve out-of-sample forecasting of the yield curve and estimate term premia that are economically plausible and consistent with survey data. Moreover, we show that volatility-induced stationarity affects the error-correcting mechanism in a system of interest rates, inflation, and real activity.

Keywords: Yield curve; error-correction; unit root; volatility-induced stationarity; macro-finance term structure model; level-dependent conditional volatility (search for similar items in EconPapers)
JEL-codes: E43 E44 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ecm, nep-ets and nep-mac
Date: 2018-12-03
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