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Estimating Diffusion Models of Interest Rates at the Zero Lower Bound: From the Great Depression to the Great Recession and Beyond

Lealand Morin (Department of Economics, University of Central Florida, United States)

Essays in Honor of Joon Y. Park: Econometric Methodology in Empirical Applications

ISBN: 978-1-83753-213-1, eISBN: 978-1-83753-212-4

Publication date: 24 April 2023

Abstract

The time series of the federal funds rate has recently been extended back to 1928, now including several episodes during which interest rates remained near the lower bound of zero. This series is analyzed, using the method of indirect inference, by applying recent research on bounded time series to estimate a set of bounded parametric diffusion models. This combination uncouples the specification of the bounds from the law of motion. Although Louis Bachelier was the first to use arithmetic Brownian motion to model financial time series, he has often been criticized for this proposal, since the process can take on negative values. Most researchers favor processes such as geometric Brownian motion (GBM), which remains positive. Under this framework, Bachelier's proposal remains valid when specified with bounds and is shown to compare favorably when modeling the federal funds rate.

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Acknowledgements

Acknowledgments

I thank Harry J. Paarsch for helpful comments on the manuscript. I am also grateful for helpful feedback on an earlier version of this manuscript from Morten Nielsen, James MacKinnon, Allan Gregory, and Prosper Dovonan, as well as from seminar participants at Queen's University and annual meetings of the Canadian Economics Association. I also gratefully acknowledge SSHRC for their generous support of this research during my doctoral studies at Queen's University. All errors are my own.

Citation

Morin, L. (2023), "Estimating Diffusion Models of Interest Rates at the Zero Lower Bound: From the Great Depression to the Great Recession and Beyond", Chang, Y., Lee, S. and Miller, J.I. (Ed.) Essays in Honor of Joon Y. Park: Econometric Methodology in Empirical Applications (Advances in Econometrics, Vol. 45B), Emerald Publishing Limited, Leeds, pp. 159-179. https://doi.org/10.1108/S0731-90532023000045B006

Publisher

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Emerald Publishing Limited