The Term Structure of Interest Rates and The Real Activity in a Sticky Price Model

Yongseung Jung

Assitant Professor, School of Law and Economics, Catholic University of Korea, Tel: +82-032-320-3573 jungys@songsim.cuk.ac.kr

JEL Classification : E52, F31

Abstract

This paper sets up a sticky price model in which money is used to reduce the transaction costs. It shows that the contemporaneous correlations between interest rates and output of the sticky price model match well the data. It also shows that a flexible price model fails to generate interest rates as inverted leading predictors of real economic activity, while a sticky price model partly has a limited success. This paper also shows that the term spread of a sticky price model partly matches the data when there is a modest nominal rigidity.

Keywords:

Leading predictors, Monetary policy, Spread, Sticky price

Acknowledgments

I would like to appreciate to Mark Bils and Tack Yun for helpful comments and conversations. All errors are my own. The author wishes to acknowledge the financial support of the Catholic University Settlement Research Fund Granted in the Program Year of 2000.

References

Abel, A. B. “Asset Prices under Habit Formation and Catching Up with Joneses.” American Economic Review Papers and Proceedings 80 (No. 2 1990): 38-42. [https://doi.org/10.3386/w3279]
Basu, S., and Fernald, J. G. “Constant Returns and Small Markups in U.S. Manufacturing.” University of Michigan, Mimeograph, 1993.
Baxter, M., and Crucini, M. “Explaining Saving/Investment Correlations.” American Economic Review 83 (No. 2 1993): 416-36.
Blanchard, O. J., and Kahn, C. M. “The Solution of Linear Difference Models under Rational Expectations.” Econometrica 48 (No. 5 1980): 1305-13. [https://doi.org/10.2307/1912186]
Calvo, G. “Staggered Prices in a Utility-Maximizing Framework.” Journal of Monetary Economics 12 (No. 3 1983): 383-98. [https://doi.org/10.1016/0304-3932(83)90060-0]
Campbell, J. Y., and Cochrane, J. H. “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior.” NBER Working Paper #4995, 1995. [https://doi.org/10.3386/w4995]
Constantinides, G. “Habit Formation: A Resolution of the Equity Premium Puzzle.” Journal of Political Economy 98 (No. 3 1990): 519-43. [https://doi.org/10.1086/261693]
Cooley, T., and Hansen, G. “Money and the Business Cycle.” In T. Cooley (ed.), Frontiers of Business Cycle Research. Princeton: Princeton University, 1995. [https://doi.org/10.1515/9780691218052]
Cox, J., Ingersoll, J., and Ross, S. “A Theory of the Term Structure of Interest Rates.” Econometrica 53 (1985): 363-408. [https://doi.org/10.2307/1911241]
Dixit, A., and Stiglitz, J. “Monopolistic Competition and Optimum Product Diversity.” American Economic Review 67 (No. 2 1977): 297-308.
Duffie, D. Dynamic Asset Pricing Theory. Princeton University Press 1996.
Eichenbaum, M., and Evans, C. L. “Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates.” Quarterly Journal of Economics 110 (No. 4 1995): 975-1010. [https://doi.org/10.2307/2946646]
Estrella, A., and Hardouvelis, G. “The Term Structure as a Predictor of Real Economic Activity.” Journal of Finance 46 (No. 2 1991): 555-76. [https://doi.org/10.1111/j.1540-6261.1991.tb02674.x]
Estrella, A., and Mishkin, F. S. “The Term Structure of Interest Rates and Its Role in Monetary Policy for the European Central Bank.” NBER Working Paper #5279, 1995. [https://doi.org/10.3386/w5279]
Fama, E. “Term Structure Forecasts of Interest Rates, Inflation, and Real Returns.” Journal of Monetary Economics 25 (No. 1 1990): 59-76. [https://doi.org/10.1016/0304-3932(90)90045-6]
Feenstra, R. C. “Functional Equivalence between Liquidity Costs and the Utility of Money.” Journal of Monetary Economics 17 (No. 2 1986): 271-91. [https://doi.org/10.1016/0304-3932(86)90032-2]
Hansen, L. P. “Large Sample Properties of Generalized Method of Moments Estimators.” Econometrica 50 (No. 4 1982): 1029-54. [https://doi.org/10.2307/1912775]
Hansen, L. P., and Singlecton, K. J. “Generalized Instrumental Variables Estimation of Nonliner Expectations Models.” Econometrica 50 (No. 3 1982): 1269-88. [https://doi.org/10.2307/1911873]
Hardouvelis, G. A. “The Real Term Structure and Consumption.” Journal of Financial Economics 22 (1988): 305-33. [https://doi.org/10.1016/0304-405X(88)90073-6]
Harvey, C. R. “The Real Term Structure and Consumption Growth.” Journal of Financial Economics 22 (No. 2 1988): 305-34. [https://doi.org/10.1016/0304-405X(88)90073-6]
Kimball, M. S. “The Quantitative Analytics of the Basic NeoMonetarist Model.” Journal of Money, Credit and Banking 27 (No. 4 1995): 1241-77. [https://doi.org/10.2307/2078048]
King, R. G., Plosser, C. I., and Rebelo, S. T. “Production, Growth, and Business CyclesⅠ. The Basic Neoclassical Model.” Journal of Monetary Economics 21 (1988): 195-232. [https://doi.org/10.1016/0304-3932(88)90030-X]
King, R. G., and Watson, M. W. “Money, Prices, Interest Rates and the Business Cycle.” Review of Economics and Statistics 78 (No. 1 1996): 35-53. [https://doi.org/10.2307/2109846]
King, R. G., and Wolman, A. L. “Inflation Targeting in a St. Louis Model of 21st Century.” NBER Working Paper #5507, 1996. [https://doi.org/10.3386/w5507]
Kydland, F. E., and Prescott, E. C. “The Workweek of Capital and Its Cyclical Implications.” Journal of Monetary Economics 21 (1988): 343-60. [https://doi.org/10.1016/0304-3932(88)90035-9]
Leeper, E. M., and Gordon, D. B. “In Search of the Liquidity Effect.” Journal of Monetary Economics 29 (No. 3 1992): 341-69. [https://doi.org/10.1016/0304-3932(92)90031-V]
Lucas, R. E., Jr. “Asset Prices in an Exchange Economy.” Econometrica 46 (No. 6 1978): 1426-46. [https://doi.org/10.2307/1913837]
Lucas, R. E., Jr. “Interest Rates and Currency Prices in a Two-Country World.” Journal of Monetary Economics 10 (No. 3 1982): 335-60. [https://doi.org/10.1016/0304-3932(82)90032-0]
Lucas, R. E., Jr. “Money Demand, A Quantitative Review.” In K. Brunner and B. Mccallum (eds.), Money, Cycles, and Exchange Rates; Essay in Honor of Alan Meltzer. Carnegie-Rochester Conference Series on Public Policy 29, Amsterdm: North Holland, 1988. [https://doi.org/10.1016/0167-2231(88)90002-4]
Mankiw, N. G., and Miron, J. A. “The Changing Behavior of the Term Structure of Interest Rates.” Quarterly Journal of Economics 101 (No. 2 1986): 211-28. [https://doi.org/10.2307/1891113]
Mankiw, N. G., and Zeldes, S. P. “The Consumption of Stockholders and Non-Stockholders.” Journal of Financial Economics 29 (No. 1 1991): 97-112. [https://doi.org/10.1016/0304-405X(91)90015-C]
Rotemberger, J. J., and Woodford, M. “Oligopolistic Pricing and the Effects of Aggregate Demand on Economic Activity.” Journal of Political Economy 100 (No. 6 1992): 1153-207. [https://doi.org/10.1086/261857]
Shiller, R. J., Campbell, J. Y., and Schoenholtz, K. L. “Forward Rates and Future Policy: Interpreting the Term Structure of the Interest Rates.” Brookings Papers on Economic Activity 1 (No. 2 1983): 173-217. [https://doi.org/10.2307/2534355]
Stock, J. W., and Waston, M. W. “Business Cycle Fluctuations in U.S. Macroeconomic Time Series.” In J. B. Taylor and M. Woodford (eds.), Handbook of Macroeconomics 1A Ch. 1 Amsterdam: Elsenvier, 1999. [https://doi.org/10.1016/S1574-0048(99)01004-6]
Stulz, R. M. “Asset Pricing and Expected Inflation.” Journal of Finance 41 (1986): 209-23. [https://doi.org/10.1111/j.1540-6261.1986.tb04500.x]
Woodford, M. “Control of the Public Debt: A Requirement for Price Stability?” NBER Working Paper #5684, 1996. [https://doi.org/10.3386/w5684]
Yun, T. “Nominal Price Rigidity, Money Supply Endogenieity, and Business Cycles.” Journal of Monetary Economics 37 (No. 2 1996): 345-70. [https://doi.org/10.1016/S0304-3932(96)90040-9]