Peter Macmillan

English

Research Papers in Economics

Understanding the yield curve, economic
structure and economic policy
Peter Macmillan1
St. Andrews University
Abstract
This version: May 2004
Building on Ellingsen and S￿derstr￿m (2001), we employ simple macroeconomic
models in order to investigate the behavior of yield curves in response to economc
structure, monetary authority preferences and aggregate demand and supply shocks.
In particular we employ two macroeconomic models, due to Svensson (1997, 1999)
and to Calvo (1983) and Yun (1996). Both models are based upon an aggregate
demand (output) and an aggregate supply (in￿ ation) relationship. In the Svensson
model in￿ ation is related to its own lag, lagged output and an additive shock; and
output is related to its own lag, the ex-poste real interest rate and an additive shock.
In the Calvo-Yun model in￿ ation is related to one period ahead expected in￿ ation,
current output and an additive shock; and output is related to one period ahead
output, the ex-ante real interest rate and an additive shock. These models may be
solved optimally for the spot short interest rate, assuming a standard inter-temporal
loss function for the monetary authority. The short spot rate may then be used to
construct expressions for both forward and spot yield curves. We then utilise UK data
on observed changes in yield curves in order to try and infer the economic structure
and monetary policy preferences within the UK. In particular, if we can identify
aggregate demand and supply shocks and a set of parameter values for our two
models, we can draw inferences regarding the change in monetary policy preference
parameters by comparing the change in the yield curve predicted by our models with
actual changes within the UK data. We select plausible parameter values for our
models through the use of full information maximum liklihood estimation techniques
on annual and quartlery data, and by appealing to the available econometric evidence.
We select aggregate demand and supply shocks for our models on the basis of UK
Treasury and private sector forecasts of in￿ ation and output.
JEL Classi￿cation: E43; F52.
Keywords: Monetary policy, yield curves, interest rate determination,
macroeconomic models.
1The
Centre for Dynamic Macroeconomic Analysis, Castlecli⁄e, The Scores, Department
of Economics, St Andrews University, UK. Tel: +44 1334 462425. E-mail: pdm1@st-
and.ac.uk. http://www.st-andrews.ac.uk/economics/sta⁄/p.macmillan.shtml
1

Understanding the yield curve, economic structure and economic policy

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