Research Discussion Paper – RDP 2008-03 Monetary Transmission and the Yield Curve in a Small Open Economy Abstract

Long-term nominal interest rates in a number of inflation-targeting small open economies have tended to be highly correlated with those of the United States. This observation has recently lent support to the view that the long end of the yield curve is determined abroad. We set up and estimate a micro-founded two-block small open economy model to study the co-movement of long-term nominal interest rates of different currencies. The expectations hypothesis together with uncovered interest rate parity, which both hold in our model, can account for much of the co-movement of interest rates observed in the data.

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