Foreign Official Holdings of U.S Treasuries, Stock Effect and the Economy: A DSGE Approach

Previous studies focus on quantifying the effect of foreign official holdings of long-term U.S Treasuries (FOHL) on the long-term interest rate. The consensus is that FOHL has a large and negative effect on the long-term interest rate. The long-term interest rate matters in determining aggregate demand, (Andres et al., 2004). However, these studies discount the macroeconomic implications of FOHL on the U.S economy. This paper extends the literature and studies the macroeconomic implications of FOHL shocks through their impact on the long-term interest rate in a dynamic stochastic general equilibrium (DSGE) model. The model treats short and long-term government bonds as imperfect substitutes through endogenous portfolio adjustment frictions(costs). Three main findings emerge from the baseline model: (1) A positive shock to FOHL impacts the long-term interest rate negatively through a stock effect channel-defined as persistent changes in interest rate as a result of movement along the Treasury demand curve. This result is consistent with the empirical literature; (2) The decline in the long-term interest rate creates favorable economic conditions that feed back into the economy and increases consumption, output and inflation through an endogenous term structure implied by the model and; (3) Monetary authority responds to the increase in inflation and output by raising the short-term interest rate. The simultaneous increase in the short-term interest rate and fall in the long-term interest rate causes the term spread to fall. This last result sheds light on the decoupling of interest rates observed between 2004-2006, a phenomenon known as the ``Greenspan Conundrum". The findings from the DSGE model are supported by impulse response functions obtained from a structural near-Vector Auto-regression(near-VAR) model.