No 42. Rational Expectations in a VAR with Markov Switching

by Mårten Blix
October 1997

Abstract

This paper shows how a well known class of rational expectations hypotheses using linear vector-autoregressions (VAR:s) can be extended to allow for unobservable Markov switching between discrete states. This statistical model differs from those commonly used in the literature: the model here is easier to estimate and has the appeal that the state dependence is symmetric. The contribution of the paper is to derive simple expressions for the VAR forecasts under Markov switching; these forecasts are then used to find testable restrictions implied by rational expectations, which are linear when the forecast horizon is infinite. As an illustration, I examine a test of the expectations hypothesis (EH) on the short end of the maturity spectrum - three and six month US bills - and find that a non-rejection of the hypothesis in a previous paper, also with regime shifts, may be fragile.

JEL Classification

No: C12, C32

Keywords

VAR, Markov Chain, regime switching, rational expectations, expectations hypothesis.