The Effect of Error-Correction on Testing the Rational-Expectations Neutrality Hypothesis

By adopting a VAR framework in first differences, recent literature has confirmed previous results in testing the macro rational-expectations hypotheses of rationality and neutrality: rationality is corroborated, neutrality is rejected. However, this paper shows that, by correctly incorporating a long-run cointegrating relationship between money, output and interest rate in the form of an error-correction term, the test results are reversed, in that neutrality is no longer rejected.