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

Author

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  • Gourinchas, Pierre-Olivier
  • Ray, Walker
  • Vayanos, Dimitri

Abstract

We develop a two-country model in which currency and bond markets are populated by different investor clienteles, and segmentation is partly overcome by arbitrageurs with limited capital. Risk premia in our model are time-varying, connected across markets, and consistent with the empirical violations of Uncovered Interest Parity and Expectations Hypothesis. Through risk premia, large-scale bond purchases lower domestic and foreign bond yields and depreciate the currency, and short-rate cuts lower foreign yields, with smaller effects than bond purchases. Currency returns are disconnected from long-maturity bond returns, and yet the currency market is instrumental in transmitting bond demand shocks across countries.

Suggested Citation

  • Gourinchas, Pierre-Olivier & Ray, Walker & Vayanos, Dimitri, 2022. "A Preferred-Habitat Model of Term Premia, Exchange Rates, and Monetary Policy Spillovers," CEPR Discussion Papers 17119, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:17119
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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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