Targeting Long Rates in a Model with Segmented Markets

This paper develops a model of segmented financial markets in which the net worth of financial institutions limits the degree of arbitrage across the term structure. The model is embedded into the canonical Dynamic New Keynesian (DNK) framework. We estimate the model using data on the term premium. Our principal results include the following. First, the estimated segmentation coefficient implies a nontrivial effect of central bank asset purchases on yields and real activity. Second, there are welfare gains to having the central bank respond to the term premium, eg., including the term premium in the Taylor rule. Third, a policy that directly targets the term premium sterilizes the real economy from shocks originating in the financial sector. A term premium peg can have significant welfare effects.