An Affine Macro-Finance Term Structure Model for the Euro Area

A joint model of macroeconomic and term structure dynamics is specified and estimated for the euro area. The model comprises a backward-looking Phillips curve, a dynamic aggregate demand equation, a monetary policy rule and a specification of the dynamics of trend growth and the natural real rate of interest. Given the linear dynamics of the macroeconomic state variables, bonds are priced under the assumption of no arbitrage. Yields of all maturities are affine functions of the state vector. The estimated model is used for policy experiments: the responses to a costpush shock, a shock to the output gap and a monetary policy shock are in general stronger for short-term rates than for long-term yields. The response to a shock to potential output growth is different in nature, though: for the first three years after the shock, the response is stronger the longer the time to maturity. For all shocks, impulse responses of bond yields are fairly persistent, which reflects the persistence of their macroeconomic driving forces.