Learning and the Yield Curve

Arunima Sinha

Journal of Money, Credit and Banking, 2016, vol. 48, issue 2-3, 513-547

Abstract: Two central implications of Expectations Hypothesis under rational expectations are inconsistent with yield curve data: (i) future expected long yields fall, instead of rising, when yield spread rises; (ii) long yields are excessively volatile relative to short yields. I propose an optimization framework in which boundedly rational agents use adaptive learning to form expectations. The belief structure rationalizes pattern of yields observed in the data so that the first puzzle does not arise with subjective expectations: intertemporal income and substitution effects are amplified relative to rational expectations. The second puzzle is partly accounted for by extra volatility due to parameter uncertainty.

Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:wly:jmoncb:v:48:y:2016:i:2-3:p:513-547

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