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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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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
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Handle: RePEc:tor:tecipa:floyd-95-01

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F3 - International Economics - - International Finance
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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  1. 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. [Downloadable!] (restricted)
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  2. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August. [Downloadable!] (restricted)
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  3. 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. [Downloadable!] (restricted)
  4. 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. [Downloadable!] (restricted)
  5. De Long, J Bradford, et al, 1989. " The Size and Incidence of the Losses from Noise Trading," Journal of Finance, American Finance Association, vol. 44(3), pages 681-96, July. [Downloadable!] (restricted)
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  6. Alan C. Stockman & Lars E.O. Svensson, 1987. "Capital Flows, Investment, and Exchange Rates," NBER Working Papers 1598, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Dornbusch, Rudiger, 1976. " The Theory of Flexible Exchange Rate Regimes and Macroeconomic Policy," Scandinavian Journal of Economics, Blackwell Publishing, vol. 78(2), pages 255-75.
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  8. 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. [Downloadable!] (restricted)
  9. Stockman, Alan C, 1980. "A Theory of Exchange Rate Determination," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 673-98, August. [Downloadable!] (restricted)
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  10. 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. [Downloadable!] (restricted)
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