Research Discussion Papers, Bank of Finland
No 18/2007:
Monetary policy, expected inflation and inflation risk premia
Federico Ravenna ()
and Juha Seppälä ()
Abstract: Within a New Keynesian business cycle model, we study
variables that are normally unobservable but are very important for the
conduct of monetary policy, namely expected inflation and inflation risk
premia. We solve the model using a third-order approximation that allows us
to study time-varying risk premia. Our model is consistent with rejection
of the expectations hypothesis and the business-cycle behaviour of nominal
interest rates in US data. We find that inflation risk premia are very
small and display little volatility. Hence, monetary policy authorities can
use the difference between nominal and real interest rates from
index-linked bonds as a proxy for inflation expectations. Moreover, for
short maturities current inflation is a good predictor of inflation risk
premia. We also find that short-term real interest rates and expected
inflation are significantly negatively correlated and that short-term real
interest rates display greater volatility than expected inflation. These
results are consistent with empirical studies that use survey data and
index-linked bonds to obtain measures of expected inflation and real
interest rates. Finally, we show that our economy is consistent with the
Mundell-Tobin effect: increases in inflation are associated with higher
nominal interest rates, but lower real interest rates.
Keywords: term structure of interest rates; monetary policy; expected inflation; inflation risk premia; Mundell-Tobin effect; (follow links to similar papers)
JEL-Codes: E43; E44; E50; G12; (follow links to similar papers)
33 pages, October 11, 2007
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