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Uncovered Interest Parity: A Further Reconsideration

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  • John E. Floyd

Abstract

This paper reexamines the uncovered interest parity condition within the context of a structural view of real exchange rate determination that emphasizes the real exchange rate as the relative price of domestic in terms of foreign output. This structural interpretation complements rather than replaces the asset-market view of nominal exchange rate determination. Because structural shocks to the real exchange rate are unpredictable, forward discounts need not predict actual future nominal exchange rate movements with any reliability, except in cases where there are continuing long-term differences in countries' inflation rates. Once the integrated nature of the world capital market is taken into account, it turns out that governments can and probably do smooth price levels, nominal exchange rates and possibly also domestic/foreign interest rate differentials, but have no power to manipulate any of these variables independently of the others. As a result, they cannot bring about major movements in real exchange rates without destabilizing the economy.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number floyd-95-01.

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Length: 30 pages
Date of creation: 13 Mar 1995
Date of revision:
Handle: RePEc:tor:tecipa:floyd-95-01

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  1. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
  2. Stockman, Alan C. & Svensson, Lars E. O., 1987. "Capital flows, investment, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 171-201, March.
  3. De Long, J Bradford, et al, 1990. " Positive Feedback Investment Strategies and Destabilizing Rational Speculation," Journal of Finance, American Finance Association, vol. 45(2), pages 379-95, June.
  4. Alan C. Stockman, 1978. "A Theory of Exchange Rate Determination," UCLA Economics Working Papers 122, UCLA Department of Economics.
  5. Dornbusch, Rudiger, 1976. " The Theory of Flexible Exchange Rate Regimes and Macroeconomic Policy," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 255-75.
  6. Helpman, Elhanan & Razin, Assaf, 1982. "Dynamics of a Floating Exchange Rate Regime," Journal of Political Economy, University of Chicago Press, vol. 90(4), pages 728-54, August.
  7. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
  8. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "The Size and Incidence of the Losses from Noise Trading," NBER Working Papers 2875, National Bureau of Economic Research, Inc.
  9. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Scholarly Articles 3445091, Harvard University Department of Economics.
  10. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring.
  11. 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.
  12. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
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