A Test of the Rational Expectations Model of the Term Structure of Interest Rates

Most tests of the rational expectations hypothesis have been rejected. The purpose of this paper is to characterize the aspects of the rational expectations model of the term structure which contribute to the rejection, rather than to merely provide testing statistics. One of the important characterizations I found is that the long term rate reacts rationally with respect to the unexpected movement of the short term rate irrespective of whether this movement is temporary or permanent over all of the studied subperiods, including 1890-1913. Secondly, the innovation to the variable term premium is orthogonal to the unexpected movement of the short term rate. Lastly, the rational expectations model does not hold over the long run movements, but does over the short run movements.