(A) model of the term structure of nominal interest rates and related issues

Abstract

A one-factor model with money is formulated to obtain an explicit expression for the term structure of nominal interest rates. Within the framework of the Cox-Ingersoll-Ross model, the demand for money is derived via a CIA constraint. Instead of an exogenous process for the money supply or the inflation rate, the endogenous money supply is incorporated into the model. The resulting nominal term structure has more flexibility than the previous one-factor models. We find evidence that empirical results favor this model against CIR-based two-factor nominal models in the Treasury bill market. The term structure of inflation expectations is obtained endogenously. The effect of changes in the real state on the expected inflation does not last long. The uncertainty of the monetary policy plays an important role in the volatility of expected inflation. Our approach suggests that the nominal term structure depend on the money supply and thus monetary policy. The term structure derived by different specifications of the money supply provides some interesting implications. Next, the behavior of yields on investment-grade corporate bonds is empirically investigated. Based on traditional asset pricing theories, we begin by regressing the yields on some information variables used in previous research. Short-term interest rate and short-maturity term premium are important variables to capture the variations in the yield spreads between corporate bonds and 3-month Treasury bills. Regime shifts in the spreads are investigated using the method of the Markov-switching model. The most important factor affecting the behavior of the spreads since the 1980s may be an anti-inflation policy in expansion periods. Changes in monetary policy do not always result in changes in the spread movements. A regime shift in the behavior of returns on other assets does not imply a regime shift in the behavior of the spreads.