Do long-term interest rates drive GDP and inflation in small open economies? Evidence from Poland

Abstract

ABSTRACTThis article investigates the impact of long-term interest rates on macroeconomic variables in a small open economy. It shows that the time-varying term premium stabilizes GDP without affecting significantly inflation volatility in Poland – a typical open economy with flexible exchange rate. This conclusion is drawn from an estimated dynamic stochastic general equilibrium model in which segmented asset markets and imperfect asset substitutability give rise to the time-varying term premium in the long-term interest rate. Furthermore, the impulse response analysis of the model reveals that the term premium stabilizes GDP when the small economy is hit by shocks that are absent in closed economy models (country risk premium and export preference) which points to the different impact of the term premium on relatively close (large) and open (small) economies.