The Term Structure of Interest Rates in a simple Stochastic Growth model: Evidence from Australian data

This paper presents a theoretical relationship between the yield curve and future economic growth in a simple stochastic growth model. The derived relationship implies that, in a simple competitive production economy, the slope of the yield curve predicts future output growth. This predictive content of the yield curve is tested using Australian data by employing a vector autoregression (VAR) method. As a way to examine the conventional view that the predictive content of the yield curve is mainly due to the liquidity effect of monetary policy operating on short term interest rates, Granger causality test is performed. The short rate is found to fail to Granger cause either the spread or the long rate. This finding does not support the conventional view that the predictive content of the yield curve is primarily due to the conduct of monetary policy.