Scandinavian Working Papers in Economics
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Bank of Finland 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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