The Yield Curve and Monetary Policy in a Small Open Economy

Abstract

This paper analyzes co-movements among the yield curves of small open countries, and the efficiency of each countrys monetary policy. First, I estimate a dynamic factor model to find common movements among the yield curves of six small open countries: Australia, Canada, Denmark, Norway, Switzerland, and the United Kingdom. The empirical results show that nominal interest rates of the countries are well-accounted for by their US counterpart, rather than the small open countries policy rates at long maturities. This may imply that the long-term rates decouple from the short-term policy rates in the small open countries, resulting in limited effects of the countries monetary policy. Thus, to examine the effectiveness of monetary policy, I analyze dynamic responses of macro variables to monetary expansions in Canada and Norway. Estimating a vector auto-regression (VAR) model, I conclude that the high yield curve correlations with the United States reduce the impacts of expansionary monetary policy in small open countries. Norway, whose interest rates are the least explained by the US rates, succeeds in boosting its economy by decreasing the policy rate. On the other hand, Canada, which has the highest yield curve correlations with its US counterpart, fails to invigorate economic activities by monetary expansion.