This thesis consists of two parts: the first examines the Expectations Hypothesis of the Term Structure for New Zealand, and the latter examines the predictive power of the term spread on future economic activity in New Zealand. For both parts, I divide the sample period into two sub-sample periods – the pre-OCR period and the OCR period.
Using Mankiw & Miron’s (1986) approach for testing the expectations hypothesis, the findings in this paper suggest that the theory is consistent with New Zealand data during the OCR period. I attribute the success of the theory to the introduction of the Official Cash Rate system in March 1999. The change from targeting the settlement cash balance to targeting an interest rate variable has substantially improved the predictability of short-term interest rates. In regards to the predictive power of the spread, the findings in this paper support the conventional view that the spread is positively related to future economic activity. Using Hamilton & Kim’s (2002) approach, I decomposed the term spread into an expectation component and a term premium in an attempt to find out whether these two variables have distinctly separate effect on future economic activity. My findings are in contrast to that reported by Hamilton & Kim. In particular, I find that the term premium in some cases is significant and negatively related to future economic activity in New Zealand. I attribute the negative relationship to lower long-term interest rates and a fallen term premium in New Zealand.