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 (CSP). 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 CSP. Specifically, it shows that, by their construction, these tests can generate results consistent with the CSP 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. [ABSTRACT FROM AUTHOR]