Volatility clustering in real interest rates Theory and evidence

Abstract

In this paper, we document that the volatility of monthly real interest rates is characterized by long periods of relatively constant volatility, interrupted by short periods of sharp increases in volatility. Moreover, volatility is correlated with measures of economic activity and financial market frictions. In particular, the conditional variance of real interest rates is negatively correlated with the growth rate of industrial production and positively correlated with the spread between the borrowing and the lending rate. We develop an equilibrium model with financial frictions that is able to mimic the observed behavior of the volatility of interest rates. The model can explain the negative correlation of the conditional variance with the business cycle and the positive correlation with the spread between the borrowing and the lending rate.