Research Discussion Papers, Bank of Finland
No 25/2006:
Monetary policy and rejections of the expectations hypothesis
Federico Ravenna ()
and Juha Seppälä ()
Abstract: We study the rejection of the expectations hypothesis
within a New Keynesian business cycle model. Earlier research has shown
that the Lucas general equilibrium asset pricing model can account for
neither sign nor magnitude of average risk premia in forward prices, and is
unable to explain rejection of the expectations hypothesis. We show that a
New Keynesian model with habit-formation preferences and a monetary policy
feedback rule produces an upward-sloping average term structure of interest
rates, procyclical interest rates, and countercyclical term spreads. In the
model, as in U.S. data, inverted term structure predicts recessions. Most
importantly, a New Keynesian model is able to account for rejections of the
expectations hypothesis. Contrary to earlier work, we identify systematic
monetary policy as a key factor behind this result. Rejection of the
expectation hypothesis can be entirely explained by the volatility of just
two real shocks which affect technology and preferences.
Keywords: term structure of interest rates; monetary policy; sticky prices; habit formation; expectations hypothesis; (follow links to similar papers)
JEL-Codes: E43; E44; E52; G12; (follow links to similar papers)
44 pages, December 14, 2006
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