By Pablo Aguilar and Jesús Vázquez
This paper introduces the term structure of interest rates into a medium-scale DSGE model. This extension results in a multi-period forecasting model that is estimated under both adaptive learning and rational expectations. Term structure information enables us to characterize agents’ expectations in real time, which addresses an imperfect information issue mostly neglected in the adaptive learning literature. Relative to the rational expectations version, our estimated DSGE model under adaptive learning largely improves the model fit to the data, which include not just macroeconomic data but also the yield curve and the consumption growth and inflation forecasts reported in the Survey of Professional Forecasters. Moreover, the estimation results show that most endogenous sources of aggregate persistence are dramatically undercut when adaptive learning based on multi-period forecasting is incorporated through the term structure of interest rates.
Adaptive learning is not new in DSGE models, but here is it done in a way that reflects current information much better than using historic information by using the yield curve. Interesting. This makes me think whether anyone used archived vintage data like from ALFRED for expectation formation.