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Do Term Premiums Matter? Transmission via Exchange Rate Dynamics

Mitsuru Katagiri and Koji Takahashi
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Mitsuru Katagiri: Bank of Japan

No 17-E-7, Bank of Japan Working Paper Series from Bank of Japan

Abstract: 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.

Keywords: Exchange Rate; Term Premium; Uncovered Interest Rate Parity (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-opm
Date: 2017-06-09
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