Essays on interest rate determination in open economies

UnrestrictedThis thesis examines how government accumulation of foreign exchange reserves affect interest rates in an open economy. In the first essay, I examine this issue from an empirical perspective. I estimate the impulse response of the 10 year Treasury yield to an exogenous innovation in Foreign Official Holdings of U.S. Long Term Treasury securities in an identified VAR model. I find that a market valuation adjustment done to the data is behind a seemingly negative effect of holdings on yields, and that once we control for this adjustment, the effect is not negative. Hence, I find no conclusive evidence of a negative effect on U.S. interest rates from foreign official accumulation of treasury bonds. In the second essay, I analyze the same question from a theoretical perspective. I present a two-country dynamic stochastic general equilibrium model in which central banks accumulate reserves and investigate whether the impulse response of one country’s interest rate is significantly negative after an exogenous shock to the other country’s foreign exchange reserve policy. I find that even in a world in which Uncovered Interest Parity (UIP) does not hold, which renders different currency assets imperfect substitutes, the response of the foreign interest rate to a home country reserve accumulation shock is likely to be negative but small in magnitude. In the third essay, I test for evidence on the mechanism used in the second essay to make different currency assets imperfect substitutes. Specifically, I estimate the elasticity of investments in foreign currencies with respect to expected excess returns. I find that currency flows help predict excess returns, and are statistically significant forecasting variables even in the presence of additional control variables. This means that demand for different currency assets is less than perfectly elastic, which lends support to the channel proposed in the second essay to introduce deviations from UIP