Testing rational expectations in a cointegrated VAR with structural change

Abstract

The rational expectation hypothesis is widely used in finance and macroeconomics. A research question investigates whether models using this hypothesis can fit the data well. Researchers have been developing econometric procedures to test rational expectation models. Sargent and Hansen (1991) proposed how to test exact rational expectation restrictions. This study aims to achieve three objectives. The first objective is to extend Johansen and Swensen’s framework that test exact rational expectation restrictions to the case where the data-generating process is a cointegrated vector autoregressive model with abrupt structural change (CVAR-SC). The second goal is to highlight that the type of rational expectation restrictions analysed in this paper imply co-breaking, as defined by Hendry and Mizon (1998). Finally, the restrictions on the CVAR-SC parameters implied by the present value model and expectation hypothesis of the interest rate term structure are analysed, derived and tested. Three empirical exercises are reported. The first is Engsted (2002)’s dataset on share prices and dividends, the second uses a Brazilian term structure data set and the third uses a North American term structure dataset.