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Monetary policy and rejections of the expectations hypothesis

  • Ravenna , Federico

    ()

    (Department of Economics, University of California)

  • Seppälä , Juha

    ()

    (Department of Economics, University of Illinois)

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.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0625netti.pdf
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Paper provided by Bank of Finland in its series Research Discussion Papers with number 25/2006.

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Length: 44 pages
Date of creation: 14 Dec 2006
Date of revision:
Handle: RePEc:hhs:bofrdp:2006_025
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/

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