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Abstract
This paper presents a simple model of the long-term interest rate. The model represents Keynes’s conjecture that the central bank’s actions influence the long-term interest rate primarily through the short-term interest rate, while allowing for other important factors. It relies on the geometric Brownian motion to formally model Keynes’s conjecture. Geometric Brownian motion has been widely used in modeling interest rate dynamics in quantitative finance. However, it has not been used to represent Keynes’s conjecture. Empirical studies in support of the Keynesian perspective and the stylized facts on the dynamics of the long-term interest rate on government bonds suggest that interest rate models based on Keynes’s conjecture can be advantageous.
Acknowledgments
The author thanks the participants in various seminars for their invaluable comments and suggestions. He also thanks Ms. Elizabeth Dunn and Ms. Mary Rafferty for their editorial assistance. This research did not receive any specific grant from funding agencies in the public, commercial or not-for-profit sectors.
Disclosure statement
The author’s institutional affiliation is provided solely for identification purposes. Views expressed are solely those of the author. The standard disclaimers hold.
The working paper version of the paper is available in the Levy Economics Institute’s working paper series: http://www.levyinstitute.org/pubs/wp_951.pdf