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Mariam Camarero, Department of Economics, Jaume I University, Avda. Sos Baynat, s/n, 12530, Castellón, Spain; E-mail [email protected]; corresponding author.
Javier Ordonez, Department of Economics, Jaume I University, Avda. Sos Baynat, s/n, 12530, Castellón, Spain; E-mail [email protected].
Cecilio Tamarit, Department of Applied Economics II, University of Valencia, Valencia P.O. Box 22.006, Spain; E-mail [email protected].
[Acknowledgment]
The authors gratefully acknowledge the financial support from the CICYT Project SEJ2005-001163 (Spanish Ministry of Education and FEDER), Generalitat Valenciana Complementary Action ACOMPLE07/102, and the Bancaja research project P1.1B2005-03. The authors are members of the Research Group "Inteco." We thank two anonymous referees for helpful comments. The usual disclaimer applies.
1. Introduction
The most recent literature on the term structure of interest rates suggests that the seminal model of Campbell and Shiller (1987), consisting of the spread and the change in the short-term rate in a vector autoregressive (VAR) specification, could be too parsimonious to fit the data (Carriero, Favero, and Kaminska 2006). In fact, this bivariate approach includes an implicit reaction function, where the only determinants of policy rates are long-term rates. Therefore, there are potential misspecifications due to the omission of macroeconomic factors. To solve this problem, some authors have considered the inclusion of other macroeconomic variables, "à la Taylor," to which monetary policymakers react. The usual potential omitted variables involved in the augmented models are internal ones, namely, inflation, output, or employment movements. However, the external determinants have been only scarcely studied.1
In this article, we propose the inclusion of a new set of variables ("à la McCallum") compatible with the endogenous policy reaction model developed by McCallum (2005). Assuming that policymakers adjust interest rates in order to keep exchange rates stable and that they are interested in smoothing interest rate movements, McCallum develops a reduced-form equation for the spot exchange rate under rational expectations. From McCallum (2005), if the European Central Bank (ECB) smoothes the path for short-run interest rates, and if it weighs in the exchange rates when formulating policy, then simple tests of the expectations hypothesis (EH) could be severely biased. Therefore, by taking into account the external influences of foreign economy, the fit of the EH may be improved. In other words, expectations of the short rate may explain a greater share...