Markov Switching Risk Premium and the Term Structure of Interest Rates: Empirical Evidence from US post-war interest rates

This paper considers the basic present value model of interest rates under rational expectations with two additional features. First, followingMcCallum (1994), themodel assumes a policy reaction function where changes in the short-term interest rate are determined by the long-short spread. Second, the short-term interest rate and the risk premium processes are characterized by a Markov regime-switching model. Using US post-war interest rate data, this paper ¿nds evidence that a two-regime switching model ¿ts the data better than the basic model. The estimation results also show the presence of two alternative states displaying quite di¿erent features