Monetary Policy and Rejections of the Expectations Hypothesis

Abstract

We study the rejection of the expectations hypothesis within a New Keynesian business cycle model. According to Backus, Gregory, and Zin (1989), 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 Buraschi and Jiltsov (2005), we identify systematic monetary policy as a key factor behind this result. Volatility in two real shocks which affect technology and preferences is sufficient to reject the expectation hypothesis with a probability larger than 95%.