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Inflation and the term structure - evidence for E.U. countries and comparisons with the United States and Japan

Objective



The understanding of the mutual dependence of inflation expectations and the term structure of interest rates is generally recognized as a crucial aspect for decisions regarding fiscal and monetary policies and financial investments. However, in spite of the large amount of work which has been provided in this field of the economic literature, so far neither a commonly accepted theoretical framework nor unambiguous empirical evidence have been produced about the relations which link actual and expected inflation to nominal and real interest rates.
The principal aim of the research work is to develop both a theoretical framework and a practical method for the analysis of the relations between inflation and interest rates.
In particular, the theoretical part will use a multifactor equilibrium model of the term structure with non-neutral inflation. The model will extend the Cox, Ingersoll and Ross (1985) framework and will allow money to play a significant role in influencing the real economy, by placing a direct link between expected inflation and real interest rates in modelling the stochastic processes which govern the dynamics of the economy (useful references in this respect may be Breeden (1986) and Pennacchi (1991)). Moreover, the theoretical framework will account for the influence of public debt and money supply on the term structure and, therefore, will also allow to study the relations which link interest rates and inflation to government budget and monetary policies. As regards the econometric methods for the estimation of the model, a cross-sectional nonlinear least squares technique (Brown and Schaefer (1994)) and a multivariate nonlinear least squares technique (Berardi (1995)) will be used. An original method based on the panel data technique will also be advanced.
The empirical work will be performed using data on E.U. countries. Moreover, a comparison between E.U. countries and the United States and Japan will be provided.
The main results expected from the research project are the following: ? the development of an innovative model which may represent a flexible tool to investigate the connections between inflation and the term structure;
? the development of econometric methodologies suitable to estimate the relations of interest and, in general, term structure models; ? empirical evidence which shows clearly the relations between inflation and the term structure in the E.U. countries and the interdependence of them with respect to shocks in those relations;
? the comparison between the different behaviour of the link inflation / term structure in E.U. and in non-E.U. countries (United States and Japan);
? empirical evidence on the effects of government debt and monetary policies on the inflation / term structure relations for both E.U. and non-E.U. countries;
? the development of software routines for the implementation of the econometric techniques used in the empirical work.
Essential references:
Cox, J.C., J.E. Ingersoll and S.A. Ross (1985): 'A theory of the term structure of interest rates', Econometrica, 53, 385-407.
Breeden, D.T. (1986): 'Consumption, production, inflation and interest rates: a synthesis', Journal of Financial Economics, 16, 3 -39. Pennacchi, G.G. (1991): 'Identifying the dynamics of real interest rates and inflation: evidence using survey data', Review of Financial Studies, 4, 53-86.
Brown, R. and S.M. Schaefer (1994): 'The term structure of real interest rates and the Cox, Ingersoll & Ross model'. Journal of Financial Economics, 35, 3-42.
Berardi, A. (1995): 'Estimating the Cox, Ingersoll and Ross model of the term structure: a multivariate approach' Ricerche Economiche 49 n. I

Funding Scheme

RGI - Research grants (individual fellowships)

Coordinator

London Business School
Address
Sussex Place Regent's Park
NW1 4SA London
United Kingdom

Participants (1)

Not available
Italy