Multimarket Expectations and The Rate of Interest

Abstract

An adequate theory of the long-term interest rate should relate the relative yields on four types of assets: money, bonds, goods, and the equity claims to the capital stock. A dynamic model, capable of empirical implementation, must also include expected future changes in the relative prices of these four assets. This paper develops such a theory of the interest rate based on multimarket expectations and shows that it is consistent with the experience of interest rates during the past two decades. In The General Theory [17] Keynes stressed the interdependence between the rate of interest and the state of expectations in the stock market. Subsequent empirical developments of the Keynesian model have, however, ignored the role of equities and focused on only two assets: bonds and money.l A particularly important aspect of our study is to reassert the joint dependence of equity and debt yields and to show the importance of expected capital gains on current bond yields. A second major purpose of this paper is to present alternatives to the traditional empirical model of expected price changes. The fixed weight autoregressive distributed lag is generalized to (1) a variable weight model, (2) a variable influence model with fixed relative weights, and (3) a model with multiple exogenous variables. Alternative methods of estimating variable weight and variable influence