Rejections of the expectations hypothesis

In this report, we will examine the rejection of the expectations hypothesis within a New Keynesian business cycle model. Previous reports indicate that the Lucas general equilibrium asset pricing model can take into account neither sign nor magnitude of average risk premia in forward prices, and is struggling to clarify rejection of the expectations hypothesis. We reveal that a New Keynesian model with habit-formation preferences and a monetary policy feedback rule generates an upward-sloping average term structure of interest rates and countercyclical term spreads. In this model, inverted term structure forecasts recessions. Best of all, a New Keynesian model has the ability to take into account rejections of the expectations hypothesis. As opposed to earlier work, we identify systematic monetary policy as a crucial factor behind this result. Rejection of the expectation hypothesis could very well be fully described by the volatility of just 2 real shocks that impact technology and preferences.

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The term structure of interest rates consists of details about agents’ expectations of future rates of interest, inflation rates, and exchange rates. Together with the high yield and commercial paper spread, the interest rate term spread among long and short maturity Treasury Bills has long been regularly proven to have predictive power for different indicators of the business cycle in the postwar period. Due to the fact that prices of securities at different maturities embody financial market participant expectations of future economic activity

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Source: Research Discussion Papers, Bank of Finland

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