Do Term Premiums Matter? Transmission via Exchange Rate Dynamics

The macroeconomic effect of term premiums is a controversial issue both theoretically and quantitatively. In this paper, we explore the possibility that term premiums affect inflation and the real economy via exchange rate dynamics. For this purpose, we construct a small open economy model with limited asset market participation, focusing particularly on the empirical fact that uncovered interest parity (UIP) tends to hold for longer-term interest rate differentials. In a quantitative exercise, we estimate parameters using Japanese and U.S. data and show that changes in the term premiums of both Japanese and U.S. long-term yields have sizable effects on Japanese inflation rates via the yen-U.S. dollar exchange rate. This result implies that although decreasing domestic term premiums increased Japan's inflation rates via the exchange rate channel to some extent, it is almost equally influenced by foreign factors such as a rise in U.S. term premium.