Rational-expectations econometric analysis of changes in regime: An investigation of the term structure of interest rates

Abstract

This paper is of interest both for its methodological contribution of new tools for analyzing rational-expectations models and for its substantive conclusions concerning the term structure of interest rates during the monetary experiment of October 1979. The paper studies systems subject to changes in regime, interpreted here as occasional, discrete shifts in the parameters governing the time series behavior of exogenous economic variables. The specification is shown to be quite tractable both theoretically and empirically. The technique is used to analyze yields on three-month Treasury bills and ten-year Treasury bonds during 1962 to 1987. A constant-parameter linear model for short-term rates is shown to be inconsistent both with the univariate time series properties of short rates and with the observed bivariate relation between long and short rates under the expectations hypothesis of the term structure. AN alternative nonlinear model that admits the possibility of changes in regime affords a much better description of the univariate process for short rates. Moreover, the cross-equation restrictions implied by the expectations hypothesis of the term structure are consistent with the nonlinear specification. Indeed, the residuals of the restricted relation have a standard error of only 0.8 basis points. This is a third less than that of a completely unrestricted linear regression of long rates on short rates, and compares with an unconditional standard deviation of long rates of 142 basis points. I conclude that once the recognition by bond traders of changes in regime is taken into account, the expectations hypothesis of the term structure of interest rates holds up fairly well for these data.