where [r.sub.m,t] is the holding-period yield between periods t and t+1 (interest being received at the end of the period) and [R.sub.t] is the holding-period yield on the benchmark asset (Barnett, 1978 and 1980).
(2) A well-known logical conundrum arises when the yield curve is inverted, such that the holding-period yield on a short-term asset that furnishes monetary services is greater than the return on a long-term asset that does not furnish monetary services.
(All rates of return are stated as annualized, one-month holding-period yields on a bond interest, or 365-day, basis.)
The second type of adjustment is to convert an annual effective yield, quoted in percentage points on a bond interest basis, to an annualized one-month holding-period yield on a bond interest basis.
The third type of adjustment is to convert an annual effective yield on a bank interest basis to an annualized one-month holding-period yield on a bond interest basis, a procedure similar to the second one.
In the fourth type of adjustment, we convert a rate quoted on a bank discount basis, for a monetary asset with a maturity of n months, to an annualized one-month holding-period yield. This conversion, which is discussed in detail by Farr and Johnson (1985), is valid only for rates with maturity of less than six months, and it assumes that each month has 30 days.
(Because these securities have no default risk, the slope of the Treasury yield curve provides a relatively "pure" estimate of the term premium.) The following discussion of yield curve adjustment assumes that all own rates (including Treasury bill rates) have been converted to an annualized one-month holding-period yield, on a bond interest basis.
The extent to which domestic monetary policy affects exchange rates--and through exchange rates, the volume of imports and exports--depends on how sensitive investors' desired portfolio allocations are to the difference between expected holding-period yields
. The greater is the sensitivity of demands--that is, the more perfect the substitution between foreign and domestic assets--the greater will be the change in the spot value of the domestic currency for a given change in the domestic interest rate, other things being equal.
2 It is necessary to measure the benchmark rate, R, to construct the Divisia monetary aggregates, and we advocate the use of the upper envelope of the yield-curve-adjusted, holding-period yields
on all of the components in the broadest aggregate.