Using a macroeconomic perspective, we examine the effect of uncertainty arising
from policy-shock volatility on yield-curve dynamics. Many macro-finance models
assume that policy shocks are homoskedastic, while observed policy shock processes
are significantly time varying and persistent. We allow for this key feature by
constructing a no-arbitrage GARCH affine term structure model, in which monetary
policy uncertainty is modeled as the conditional volatility of the error term in a
Taylor rule. We find that monetary policy uncertainty increases the medium- and
longer-term spreads in a model that incorporates macroeconomic dynamics.
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