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When does uncovered interest parity hold?

Author

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  • Moore, Michael J.
  • Roche, Maurice J.

Abstract

A consensus is emerging that returns to the currency carry trade are driven by two factors. One of these is probably consumption risk but there is widespread disagreement about the identity of the remaining factor. This paper bolsters the case for volatility being the unknown factor. A structural model that specifies that monetary volatility is the second factor is tested for 56 monetary regimes using the artificial economy methodology. The negative slope in the Fama regression arises when monetary volatility is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary volatility is high, the Fama slope is positive in line with uncovered interest parity. We conclude that, given the predominance of precautionary savings, the degree of monetary volatility explains whether uncovered interest parity holds.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:jimfin:v:31:y:2012:i:4:p:865-879
    DOI: 10.1016/j.jimonfin.2012.01.005
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    References listed on IDEAS

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    Keywords

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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