Working Paper: NBER ID: w27615
Authors: Robin Greenwood; Samuel G. Hanson; Jeremy C. Stein; Adi Sunderam
Abstract: We develop a model in which specialized bond investors must absorb shocks to the supply and demand for long-term bonds in two currencies. Since long-term bonds and foreign exchange are both exposed to unexpected movements in short-term interest rates, a shift in the supply of long-term bonds in one currency influences the foreign exchange rate between the two currencies, as well as bond term premia in both currencies. Our model matches several important empirical patterns, including the co-movement between exchange rates and term premia, as well as the finding that central banks' quantitative easing policies impact exchange rates. An extension of our model sheds light on the persistent deviations from covered interest rate parity that have emerged since 2008.
Keywords: term premia; exchange rates; quantitative easing
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increase in the supply of long-term U.S. bonds (E43) | Rise in the expected excess return on these bonds (G12) |
| Rise in the expected excess return on these bonds (G12) | Euro depreciates against the dollar (F31) |
| Increase in the supply of long-term U.S. bonds (E43) | Euro depreciates against the dollar (F31) |
| Shifts in long-term interest rates (E43) | Response of exchange rates (F31) |
| Shifts in short-term interest rates (E43) | Response of exchange rates (F31) |
| Correlation between domestic and foreign short rates (E43) | Transmission of supply shocks across markets (E44) |
| Lower correlation (C10) | Larger impacts on exchange rates (F31) |