DP17119 A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers

Author(s): Pierre-Olivier Gourinchas, Walker Ray, Dimitri Vayanos
Publication Date: March 2022
Keyword(s): Exchange Rates, interest rates, Limits of arbitrage, monetary policy
JEL(s): E43, F41, G15
Programme Areas: Financial Economics, International Macroeconomics and Finance, Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=17119

We develop a two-country model in which currency and bond markets are populated by different investor clienteles, and segmentation is partly overcome by global arbitrageurs with limited capital. Our model accounts for the empirically documented violations of Uncovered Interest Parity (UIP) and the Expectations Hypothesis, and for how UIP violations depend on bond maturity, investment horizon, and yield curve slope differentials. Large-scale purchases of long-maturity bonds lower domestic and foreign bond yields, and depreciate the currency. Conventional monetary policy is transmitted to domestic and international bond yields as well, but its international transmission is weaker than for unconventional policy.