Working Paper

Tests of the expectations hypothesis: resolving the Campbell-Shiller paradox

Abstract: One of the more puzzling results in the expectations hypothesis (EH) testing literature is the Campbell-Shiller paradox. In an influential paper, Campbell and Shiller (1991) found that ?the slope of the term structure almost always gives a forecast in the wrong direction for the short-term change in the yield on the longer bond, but gives a forecast in the right direction for long-term changes in short rates.? This paper provides an econometric resolution to the Campbell-Shiller paradox. Specifically, it shows that, by their construction, these tests can generate results consistent with the Campbell-Shiller paradox if the EH does not hold?whatever the reason. Monte Carlo experiments confirm that this explanation can account for Campbell and Shiller?s paradoxical results for most pairings of short-term and long-term rates considered.

Keywords: Rational expectations (Economic theory);

Status: Published in Journal of Money, Credit, and Banking, March 2006, 38(2), pp. 511-42

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2004

Number: 2003-022