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Tests of the Expectations Hypothesis: Resolving the Campbell-Shiller Paradox

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.

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