Testing the rationality of exchange rate and interest rate expectations: an empirical study of Australian survey-based expectations

Abstract

This paper examines the rationality of the Australian survey-based expectations, 1- and 4-week-ahead $US/$A exchange rate and 2 and 4-week-ahead Australian 90-day bank bill and 10-year bond rates. The actual and expected variables are found to be cointegrated, indicating that the expected future values and the future realizations of the exchange rate and interest rates have long-run equilibrium relationships. OLS estimations with the Newey - West corrections are employed for testing the unbiased expectations hypothesis (UEH) where the frequency of the expectations data is finer than the forecast horizons, and the exponential-GARCH models that take into account the time-varying nature of the forecasterror variance are employed for testing the weak rational expectations hypothesis (WREH). The evidence shows that the WREH could not be rejected in any case, except for the two-week-ahead forecast of the 90-day interest rate, which indicates that all available information is used at the time of forming relevant forecasts. The UEH, however, is decisively rejected in all cases. This indicates that strong rationality, which requires both UEH and WREH, is rejected in all cases. It is concluded that forecasters are weakly rational; however, their forecasts are not unbiased because the data available to them when forming expectations are inadequate.