Abstract

This paper uses cointegration and common trends techniques to investigate empirically the expectations hypothesis of the term structure of interest rates among the original 15 EU countries. By decomposing each term structure into its transitory and permanent components, we also examine whether the short or the long rate is weakly exogenous and thus determine the long run behavior of each term structure. The empirical results support the expectations theory of the term structure of interest rates for all the EU-15 countries. They also indicate that the long term interest rates are weakly exogenous for almost all the countries in our sample. Further, we investigate if the expectation theory of the term structure of interest rates is affected by other exogenous variables such as nominal and real exchange rates, inflation rates, inflation variance, money growth and its variance. Our evidence suggests that the inclusion of the other exogenous variables does not affect the expectations hypothesis for most of the EU-15 countries. <div>Also available for download here: http://ideas.repec.org/p/crt/wpaper/0611.html</div>

Highlights

  • The term structure of interest rates, which gives the yield to maturity of all securities of all maturities at a given point in time, has been the focus among monetary economist and monetary policy officials for a long time

  • Based on the The Netherlands CEs (Trace) and the λmax statistics at the 10 percent level of significance4, we find evidence of p−1 cointegrating relations and a single shared common trend for Austria, Belgium, Denmark, Finland, Greece, The Netherlands, Sweden and the United Kingdom, in full consistency with the expectations theory of the term structure (ETTS)

  • Since the interest rates follow random walks, we evaluated the expectations hypothesis of the term structure using cointegration analysis and common trends techniques

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Summary

Introduction

The term structure of interest rates, which gives the yield to maturity of all securities of all maturities at a given point in time, has been the focus among monetary economist and monetary policy officials for a long time. If the expectations theory of the term structure is correct, an upward slopping yield curve reflect expectations of rising future short rates Such expectations could be caused by many factors, including increased uncertainty about future economic conditions, inflationary expectations or uncertainty about government policies. Even though most of the studies to date have been concerned with testing the ETTS for a specific country or group of countries, the decomposition of the term structure into its transitory (i.e. the I(0) cointegrating relations) and permanent (i.e. the I(1) common trends) components can be useful and insightful. The results indicate that the inclusion of the exogenous variables does not affect the expectations hypothesis for almost all the EU-15 countries Such analysis is useful to policy makers who wish to know where the short term or the long term interest rate is an exogenous variable.

The ETTS of Interest Rates
The Johansen Models for Cointegration and Common Trends
The Pesaran-Shin-Smith (PSS) Models for Cointegration, with Exogenous I(1) Variables in the VECMs
Data and Empirical Results
Testing for the ETTS
Common Trends Results
Testing for the ETTS, with Exogenous I(1) Variables in the VECMs
Concluding Remarks
Full Text
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