Working Paper: CEPR ID: DP17119
Authors: Pierre-Olivier Gourinchas; Walker Ray; Dimitri Vayanos
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.
Keywords: exchange rates; interest rates; monetary policy; limits of arbitrage
JEL Codes: E43; F41; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| large-scale purchases of long-maturity bonds (G15) | lower domestic bond yields (E43) |
| large-scale purchases of long-maturity bonds (G15) | lower foreign bond yields (E43) |
| large-scale purchases of long-maturity bonds (G15) | depreciation of the currency (F31) |
| conventional monetary policy (E52) | domestic bond yields (H63) |
| conventional monetary policy (E52) | international bond yields (E43) |
| home short rate cut (G21) | expected return of currency carry trades increases (F31) |
| home short rate cut (G21) | smaller appreciation of the exchange rate (F31) |
| home short rate cut (G21) | expected return of bond carry trades increases (E43) |
| home short rate cut (G21) | rise in bond prices (G12) |
| rise in bond prices (G12) | less than expected drop in bond yields (E43) |
| risk aversion of arbitrageurs (D81) | expected returns from currency carry trades (F31) |
| risk aversion of arbitrageurs (D81) | expected returns from bond carry trades (E43) |