No abstract

No abstract

We study the rejection of the expectations hypothesis within a New Keynesian business cycle model. Earlier research has shown that the Lucas general equilibrium asset pricing model can account for neither sign nor magnitude of average risk premia in forward prices, and is unable to explain rejection of the expectations hypothesis. We show that a New Keynesian model with habitformation preferences and a monetary policy feedback rule produces an upwardsloping average term structure of interest rates, procyclical interest rates, and countercyclical term spreads. In the model, as in U.S. data, inverted term structure predicts recessions. Most importantly, a New Keynesian model is able to account for rejections of the expectations hypothesis. Contrary to earlier work, we identify systematic monetary policy as a key factor behind this result. Rejection of the expectation hypothesis can be entirely explained by the volatility of just two real shocks which affect technology and preferences.

This paper argues that a simple general equilibrium model can explain two of the most persistent term structure puzzles. First, Donaldson, Johnsen, and Mehra 1990 show that while in the U.S. nominal term structure the interest rates are pro-cyclical and term spreads counter-cyclical the stochastic growth model predicts that the interest rates are counter-cyclical and term spreads pro-cyclical. The resolution of this puzzle is simple. Using the data on the U.K. index-linked bonds, I show that during the sample period 1984:1 1995:8 the ex-ante real interest rates were counter-cyclical and term spreads pro-cyclical. Second, according to Backus, Gregory, and Zin 1989 a complete markets model can account for neither the sign nor the magnitude of average risk premiums in forward prices. This paper applies recent research by Alvarez and Jermann 1999ab to the term premium puzzle. It is shown that the model A previous version of this paper was circulated under the title The Term Structure of Interest Rates under Limited Commitment." Current v ersion is preliminary and incomplete. Comments are most welcome. Revisions can bedownloaded from http: home.uchicago.edu ~jiseppal research.

Within a New Keynesian business cycle model, we study variables that are normally unobservable but are very important for the conduct of monetary policy, namely expected inflation and inflation risk premia. We solve the model using a third-order approximation that allows us to study time-varying risk premia. Our model is consistent with rejection of the expectations hypothesis and the businesscycle behaviour of nominal interest rates in US data. We find that inflation risk premia are very small and display little volatility. Hence, monetary policy authorities can use the difference between nominal and real interest rates from index-linked bonds as a proxy for inflation expectations. Moreover, for short maturities current inflation is a good predictor of inflation risk premia. We also find that short-term real interest rates and expected inflation are significantly negatively correlated and that short-term real interest rates display greater volatility than expected inflation. These results are consistent with empirical studies that use survey data and index-linked bonds to obtain measures of expected inflation and real interest rates. Finally, we show that our economy is consistent with the Mundell-Tobin effect: increases in inflation are associated with higher nominal interest rates, but lower real interest rates.