The equation, for example, significantly underpredicts the level of the short rate
One explanation for this difference is that the short rate
can be what is called "mean-reverting," i.
During a press conference, Fed Chairman Bernanke re-emphasized that the economic data will be driving the Fed's decisions ahead, both on "taper" and on short rate
This equivalently means that the difference between the long rate and short rate
is the sum of a weighted average of expected changes in future short rates
and a function of the risk premium.
With flat demand curves, the relative supplies of the assets do not matter because they do not affect the current short rate
or future expectations of the short rate
The second factor is closely related to the spread between the long and the short rate
and appears to be important, as the highest is the period studied.
What our analysis missed a generation ago was that the typical model with only one interest rate could not possibly allow for stabilizing market responses in long rates when the central bank set the short rate
On the other hand, linearity cannot be rejected for the error-correction model with M0 and the short rate
Note that the single-factor model actually depends on two short rate
In models a la Vasicek, the expected future short rates
are consistent with an exogenously specified process for the short rate
in the difference between the current short rate
and the stochastic trend.
They take a one-month maturity for the short rate
and a three-month maturity for the long rate and consider the period October 1987 to November 1995.