We test the expectations hypothesis (EH) of the term structure of interest
rates for the German money market at the short end of the maturity spectrum
using a variety of metrics, and on balance we argue that the results tend
to broadly support the hypothesis. We utilise monthly data on pure discount
bonds with a maturity from 1 to 12 months over the period of 1976 to 1993.
The VAR methodology is used to forecast future interest rates which, under
the EH, results in a set of cross-equation restrictions as well as tests b
ased on the correspondence between the best forecast (referred to as the 't
heoretical spread') and the actual spread. The VAR methodology allows expli
cit consideration of potential non-stationarity in the data as do our tests
based on the cointegration literature. We also perform more conventional t
ests, based on applying the rational expectations (RE) hypothesis in a sing
le equation framework. Our relatively favourable results for the EH are in
sharp contrast to those found in studies using US data and this we attribut
e in part to the policy of sustained credible monetary targeting by the Bun
desbank. (C) 2000 Elsevier Science B.V. All rights reserved.