RDP 2008-03: Monetary Transmission and the Yield Curve in a Small Open Economy 6. Conclusion

Recently, long-term nominal interest rates in inflation-targeting small open economies, like Australia, Canada, New Zealand, Norway, Sweden and the UK, have moved very closely with those of the US. This observation has led many to the view that the long end of the domestic yield curve is determined abroad, and with it, to a concern that the monetary transmission mechanism of small open inflation-targeting economies may be weaker than it otherwise might be.

In this paper we have set up a fully micro-founded two-block small open economy model to study the co-movement of interest rates across the yield curve of different countries. We have shown that the reduced-form correlations at the short and long end of the domestic and foreign yield curves can be explained by a model in which the expectations hypothesis and uncovered interest rate parity hold. In particular, longer-term domestic interest rates in the model are always linked to the expected future path of the domestic short-term nominal interest rate. Nevertheless, if foreign shocks are more persistent than domestic shocks, then it makes sense that long-term nominal interest rates in the small and large economies are highly correlated, while the correlation between short-term nominal interest rates and long-term nominal interest rates is relatively low. In short, the reduced-form correlations do not imply that long-term nominal interest rates in small open economies are determined abroad.