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Solving the Forward Discount Bias Puzzle in a Small Open Developing Economy

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  • Bilesha B. Weeraratne

    (Bilesha B. Weeraratne is a PhD candidate in Economics at the Graduate Center, City University of New York. Email: BWeeraratne@gc.cuny.edu)

Abstract

This article tests the validity of a Forward Discount Bias Puzzle, in a small open developing economy (SODE)—Sri Lanka—by employing first an unstructured vector autoregression (VAR) model and then a structured VAR model. The author argues that empirical examinations concerning SODEs cannot merely replicate methodology followed in testing developed economies, and identifies the need to disentangle capital flows from interest rate changes by including both capital flow and monetary policy variables. The article finds no evidence of a Forward Discount Bias Puzzle in Sri Lanka, and that perfect capital mobility is a too strong assumption. Hence, it proves that empirically more appropriate approach is to assume some capital mobility and incorporate capital flow data to accommodate for this change, in the analysis of UIRP.

Suggested Citation

  • Bilesha B. Weeraratne, 2011. "Solving the Forward Discount Bias Puzzle in a Small Open Developing Economy," South Asia Economic Journal, Institute of Policy Studies of Sri Lanka, vol. 12(1), pages 61-89, March.
    • Handle: RePEc:sae:soueco:v:12:y:2011:i:1:p:61-89
    DOI: 10.1177/139156141001200104
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    References listed on IDEAS

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    More about this item

    Keywords

    JEL: F21; JEL: F31; JEL: F32; JEL: F41; Foreign exchange; international capital flows; Sri Lanka; developing country; small open economy;
    All these keywords.

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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