Although the expectations theory is the dominant model of long-term interest rate determination, empirical studies often reject its implications. Taking the theory as a benchmark, the authors work to quantify the influence of expectations. They find support for two key implications: that permanent shifts in short-term rates should have a one-for-one effect on long-term rates and that the spread between long and short rates should reflect temporary shifts in short rates. They also find evidence that a common stochastic trend in interest rates is particularly important for the long rate and that temporary deviations from this trend are particularly important for the spread. Although detailed rational expectations restrictions implied by the term structure theory are rejected for U.S. data, the authors nevertheless conclude that the expectations theory remains a useful tool in applied contexts and provide two rules of thumb for practitioners.
Amanda L. Kramer
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