News Shocks and the Term Structure of Interest Rates: A Challenge for DSGE Models

Christopher Otrok and André Kurmann

No 426, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: News shocks about future increases in Total Factor Productivity (TFP) lead to a large and persistent drop in inflation and the Federal Funds rate while driving up the slope of the term structure of interest rates (Kurmann and Otrok, 2010). In this paper, we first show that a monetary DSGE model with a standard parametrization along the lines of Smets and Wouters (2007) is unable to replicate these dynamics. We then formally estimate the model with a limited-information procedure that is designed to match as closely as possible the impulse responses of key macroeconomic aggregates, inflation and the term structure to TFP news shocks. When we restrict parameters to economically meaningful values, the model is unable to generate the large drop in inflation and the Federal Funds rate that causes the slope of the term structure to increase. This failure to quantitatively account for the impact of TFP news shocks represents a challenge for modern DSGE models because TFP news shocks explain a significant portion of the variation in inflation, the Federal Funds rate and the term structure of interest rate as well as medium-run fluctuations in future real activity.

Date: 2011
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