The Canadian macroeconomy and the yield curve: an equilibrium‐based approach

Abstract

Abstract. The authors develop and estimate an equilibrium‐based model of the Canadian term structure of interest rates. The proposed model incorporates a vector‐autoregression description of key macroeconomic dynamics and links them to those of the term structure, where identifying restrictions are based on the first‐order conditions that describe the representative investor's optimal consumption and portfolio plan. A remarkable result is that the in‐sample average pricing errors obtained with the equilibrium‐based model are only slightly larger than those obtained with a far more flexible no‐arbitrage model. The gains associated with parsimony become obvious out‐of‐sample, where the equilibrium model delivers much more accurate predictions, especially for yields with longer‐term maturities. The preferred equilibrium model has impulse responses that are consistent with long‐term inflation expectations being anchored, so a surprise increase in inflation does not necessarily raise expectations of higher future inflation.

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