Measuring the credibility of monetary policy using the term structure of interest rates

Mogodi, Keitumetse
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The study of the expectations hypothesis has been one which has led to much rejection and acceptance in relation to the term structure of interest rates. This paper seeks to observe how the credibility of central banks is affected by the different regimes and developments over time such as the US sub-prime mortgage crisis. The observation will be conducted in the context of advanced and emerging market economies. Therefore, a measure of central bank credibility is hypothesized and measured using the yield spread where short term rates and tests of significance is used extensively. In addition, the study will go further to test the how the conduct of central banks money supply affect expected rates. This allows us to unfold how a market efficiently responds greatly to unanticipated interest rate movement or policy regime changes rather than central bank announcements Findings of this study validates that the credibility of central banks is evaluated greatly through the short interest rate as well as previous expected rates. On this basis, the study thus accepts the notion that the yield curve contains information in correspondence to the expectations hypothesis which aid in predicting future expected interest rates. Furthermore, future expected rates decay after a lag for most countries. In practical terms for a successive monetary policy, central banks should carry out an optimal rule-like behaviour bearing in mind to consider unexpected contingencies which could affect its credibility. This is especially in response to current unconventional policies sanctioned post US subprime crisis. Therefore, a recommendation for central banks to be successive would be to strike a good balance between the credibility of its announcements and the flexibility to adjust to unanticipated events.
Thesis submitted in part of the requirements for the degree of Masters of Management in Finance and Investment in the Faculty of Commerce, Law and Management Wits Business School at the University of the Witwatersrand 2017