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Monetary Policy and the Uncovered Interest Parity Puzzle

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  • David K. Backus
  • Federico Gavazzoni
  • Christopher Telmer
  • Stanley E. Zin

Abstract

High interest rate currencies tend to appreciate. This is the uncovered interest rate parity (UIP) puzzle. It is primarily a statement about short-term interest rates and how they are related to exchange rates. Short-term interest rates are strongly affected by monetary policy. The UIP puzzle, therefore, can be restated in terms of monetary policy. Do foreign and domestic monetary policies imply exchange rates that violate UIP? We represent monetary policy as foreign and domestic Taylor rules. Foreign and domestic pricing kernels determine the relationship between these Taylor rules and exchange rates. We examine different specifications for the Taylor rule and ask which can resolve the UIP puzzle. We find evidence in favor of a particular asymmetry. If the foreign Taylor rule responds to exchange rate variation but the domestic Taylor rule does not, the model performs better. A calibrated version of our model is consistent with many empirical observations on real and nominal exchange rates, including Fama's negative correlation between interest rate differentials and currency depreciation rates.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16218.

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Date of creation: Jul 2010
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Handle: RePEc:nbr:nberwo:16218

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  1. Don E. Schlagenhauf & Jeffrey M. Wrase, 1992. "Liquidity and real activity in a simple open economy model," Discussion Paper / Institute for Empirical Macroeconomics 57, Federal Reserve Bank of Minneapolis.
  2. Riccardo Colacito & Mariano Croce, 2005. "Risks For The Long Run And The Real Exchange Rate," 2005 Meeting Papers 794, Society for Economic Dynamics.
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  9. Hollifield, Burton & Uppal, Raman, 1997. " An Examination of Uncovered Interest Rate Parity in Segmented International Commodity Markets," Journal of Finance, American Finance Association, vol. 52(5), pages 2145-70, December.
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Cited by:
  1. Andrew Ang & Allan Timmermann, 2012. "Regime Changes and Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 313-337.
  2. Greg Farrell & Shakill Hassan & Nicola Viegi, 2012. "The High-Frequency Response of the Rand-Dollar rate to Inflation Surprises," Working Papers 279, Economic Research Southern Africa.
  3. Charles Engel, 2011. "The Real Exchange Rate, Real Interest Rates, and the Risk Premium," NBER Working Papers 17116, National Bureau of Economic Research, Inc.
  4. Henriksen, Espen & Kydland, Finn E. & Šustek, Roman, 2013. "Globally correlated nominal fluctuations," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 613-631.
  5. Hanno Lustig & Nikolai Roussanov & Adrien Verdelhan, 2010. "Countercyclical Currency Risk Premia," NBER Working Papers 16427, National Bureau of Economic Research, Inc.
  6. Victoria Galsband & Thomas Nitschka, 2013. "Currency excess returns and global downside market risk," Working Papers 2013-07, Swiss National Bank.
  7. Jeremy Graveline & Irina Zviadadze & Mikhail Chernov, 2012. "Crash Risk in Currency Returns," 2012 Meeting Papers 753, Society for Economic Dynamics.
  8. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  9. Gianluca Benigno & Pierpaolo Benigno & Salvatore Nisticò, 2011. "Risk, Monetary Policy and the Exchange Rate," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 247-309 National Bureau of Economic Research, Inc.
  10. Ian Martin, 2011. "The Forward Premium Puzzle in a Two-Country World," NBER Working Papers 17564, National Bureau of Economic Research, Inc.
  11. Moore, Michael J. & Roche, Maurice J., 2012. "When does uncovered interest parity hold?," Journal of International Money and Finance, Elsevier, vol. 31(4), pages 865-879.
  12. Alfred Guender, 2011. "CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules," Working Papers in Economics 11/18, University of Canterbury, Department of Economics and Finance.

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