Long-term interest rates in a number of small-open inflation targeting economies co-move more strongly with US long-term rates than with short-term rates in those economies. We augment a standard small open-economy model with imperfectly substitutable government bonds and timevarying term premia that captures this phenomenon. The estimated model fits a range of US and UK data remarkably well, and produces term premium estimates that are comparable to estimates from the affine term structure model literature. We find that the strong co-movement between US and UK long-term interest rates arises primarily via correlated policy rate expectations, rather than through correlated term premia. This is due to policymakers in both economies responding to foreign productivity and discount factor shocks that cause persistent changes in inflation. We also overcome the common failure of similar models to account for the large influence of foreign disturbances on domestic economies found empirically, where in our model around 40% of the variation in UK GDP can be explained by shocks originating in the US economy.JEL Classification: E43, E44, F30, F44, F65, G15

A new method for estimating Bayesian vector autoregression (VAR) models using priors from a dynamic stochastic general equilibrium (DSGE) model is presented. The DSGE model priors are used to determine the moments of an independent Normal-Wishart prior for the VAR parameters. Two hyper-parameters control the tightness of the DSGE-implied priors on the autoregressive coefficients and the residual covariance matrix respectively. Selecting the values of the hyper-parameters that maximize the marginal likelihood of the Bayesian VAR provides a method for isolating subsets of DSGE parameter priors that are at odds with the data. The ability of the new method to correctly detect misspecified DSGE priors is illustrated using a Monte Carlo experiment. The method gives rise to a new 'quasi-Bayesian' estimation approach: posterior estimates of the DSGE parameter vector can be recovered from the BVAR posterior estimates. An empirical application on US data reveals economically meaningful differences in posterior parameter estimates when comparing the quasi-Bayesian estimator with Bayesian maximum likelihood. The new method also indicates that the DSGE prior implications for the residual covariance matrix are at odds with the data.

Long-term interest rates of small open economies correlate strongly with the US long-term rate. Can central banks in those countries decouple from the US? An estimated DSGE model for the UK (vis-à-vis the US) establishes three structural empirical results. (1) Comovement arises due to nominal fluctuations, not through real rates or term premia. (2) The cause of comovement is the central bank of the small open economy accommodating foreign inflation trends, rather than systematically curbing them. ( 3) Small open economies may find themselves much more affected by changes in US inflation trends than the US itself. All three results are shown to be intuitive and backed by off-model evidence.

No abstract

No abstract