Expectations Hypotheses Tests and Predictive Regressions at Long Horizons

Many rational expectations models state that an economic variable is determined as the present value of future variables. These restrictions have traditionally been tested on VARs where variables appear either in levels (or cointegrating relationships) or first differences. Commonly used test statistics may lead to over-rejections in small samples in the presence of highly persistent variables. Similar problems occur in longhorizon predictive regressions. We propose an alternative method based on local-tounity asymptotic approximations. We apply this method to long-horizon Predictive Regressions, Uncovered Interest Rate Parity, the Term Structure, and the Permanent Income Hypothesis.