The Term Structure of Interest Rates In the MIT-PENN-SSRC Model: Reality or Illusion?

THE IS-LM MODEL of income and expenditure, which is the conceptual foundation for large econometric models, contains only a single interest rate. Under standard interpretations of the model, however, investment expenditures depend on long-term rates of interest and the demand for money responds to short-term yields . Textbooks avoid the issue by adopting the fiction of a single rate of interest. Outside the classroom the question of the term structure of interestrates and ie link between monetary and expenditure sectors reappears. The problem is resolved in most large econometric models by an equation that expresses long-term interest rates as depending primarily on a long distibuted lag of current and past short-term yields .1 The justification for this approach rests primarily on work by Modigliani and Sutch [24, 25] and Modigliani and Shiller [23]. The Modigliani-Shiller model of the term structure is the primary channel irough which monetary policy in the MIT-PENN-SSRC model alters prices, income, and employment.2 There is, however, a large and growing body of empirical evidence indicating iat