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Can Endogenous Monetary Policy Explain the Deviations from UIP

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  • Alexius, Annika

    (Department of Economics)

Abstract

The co-movements of nominal exchange rates and short-term interest rates as the economy is hit by shocks is a potential source of ex post deviations from uncovered interest rate parity. This paper investigates whether an established model of endogenous monetary policy in an open economy is capable of explaning the exchange rate risk premium puzzle. Time series on interest differentials and exchange rate changes are generated from the Svensson (2000) model. Uncovered interest rate parity is tested on the simulated data and the b-coefficients are investigated. For most realistic choices of parameter values, the b-coefficients are positive but much smaller than the unity value expected from UIP. It is however also possible to obtain large, negative b-coefficients if the central bank is engaged in interest rate smoothing.

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Bibliographic Info

Paper provided by Uppsala University, Department of Economics in its series Working Paper Series with number 2002:17.

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Length: 34 pages
Date of creation: 15 Aug 2002
Date of revision:
Handle: RePEc:hhs:uunewp:2002_017

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Postal: Department of Economics, Uppsala University, P. O. Box 513, SE-751 20 Uppsala, Sweden
Phone: + 46 18 471 25 00
Fax: + 46 18 471 14 78
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Web page: http://www.nek.uu.se/
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Keywords: Monetary policy; Uncovered interest parity; Exchange rate risk premium;

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  1. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  2. Alexius, Annika & Sellin, Peter, 1997. "A Latent Factor Model of European Exchange Rate Risk Premia," Working Paper Series in Economics and Finance 156, Stockholm School of Economics.
  3. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
  4. Svensson, Lars E.O., 1997. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Seminar Papers 615, Stockholm University, Institute for International Economic Studies.
  5. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  6. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June.
  7. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
  8. Alexius, Annika, 2000. "UIP for Short Investments in Long-Term Bonds," Working Paper Series 115, Sveriges Riksbank (Central Bank of Sweden).
  9. Lars E. O. Svensson, 1997. "Inflation Targeting: Some Extensions," NBER Working Papers 5962, National Bureau of Economic Research, Inc.
  10. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  11. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
  12. Hodrick, Robert J. & Srivastava, Sanjay, 1986. "The covariation of risk premiums and expected future spot exchange rates," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages S5-S21, March.
  13. Kenneth A. Froot and Jeffrey A. Frankel., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Economics Working Papers 8874, University of California at Berkeley.
  14. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy Rules for Inflation Targeting," NBER Working Papers 6512, National Bureau of Economic Research, Inc.
  15. Robert J. Hodrick, 1987. "Risk, Uncertainty and Exchange Rates," NBER Working Papers 2429, National Bureau of Economic Research, Inc.
  16. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  17. Robert P. Flood & Mark P. Taylor, 1996. "Exchange Rate Economics: What's Wrong with the Conventional Macro Approach?," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 261-302 National Bureau of Economic Research, Inc.
  18. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  19. Mark P. Taylor & Ronald MacDonald, 1991. "Exchange Rate Economics: A Survey," IMF Working Papers 91/62, International Monetary Fund.
  20. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
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  22. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
  23. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  24. Gilles Oudiz & Jeffrey Sachs, 1985. "International Policy Coordination In Dynamic Macroeconomic Models," NBER Chapters, in: International Economic Policy Coordination, pages 274-330 National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Carlo A. Favero & Francesco Giavazzi, 2004. "Inflation Targeting and Debt: Lessons from Brazil," NBER Working Papers 10390, National Bureau of Economic Research, Inc.
  2. Alex Luiz Ferreira, 2008. "The Simultaneity Bias of the Uncovered Interest Rate Parity: Evidence for Brazil," Working Papers 08_20, Universidade de São Paulo, Faculdade de Economia, Administração e Contabilidade de Ribeirão Preto.
  3. Gottfries, Nils, 2003. "Booms and Busts in EMU," Working Paper Series 2003:29, Uppsala University, Department of Economics.

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