Monetary policy and rejections of the expectations hypothesis

Federico Ravenna and Juha Seppälä

No 25/2006, Bank of Finland Research Discussion Papers from Bank of Finland

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 habitformation preferences and a monetary policy feedback rule produces an upwardsloping 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 (search for similar items in EconPapers)
JEL-codes: E43 E44 G12 (search for similar items in EconPapers)
Date: 2006
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