The Term Structure of Interest Rates in a New Keynesian Model with Time-Varying Macro Volatility

We show that the New Keynesian sticky price model with a cost-push shock and time-varying volatilities of driving forces can reproduce the behavior of the U.S. yield curve in the post-World War II period. Furthermore, we examine how the yield data affects the estimation of time-varying volatilities. We find that if we omit the cost-push shock, we can get very different estimates of the inflation target volatility depending on whether or not we use yield data in addition to macroeconomic data. Therefore, the cost-push shock is crucial for a good prediction of the yield curve. We finally show that the slope of the yield curve depends negatively on both the volatility of the inflation target and the volatility of the cost-push shock.