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Systematic monetary policy and the forward premium puzzle

  • Demosthenes N. Tambakis
  • Nikola Tarashev

Is systematic monetary policy a driver of the forward premium puzzle, i.e. the tendency of high interest-rate currencies to appreciate, thus strongly violating Uncovered Interest Parity (UIP)? We address this question by studying a battery of monetary policy rules in a small open economy that is subject to stationary but persistent domestic and foreign shocks. Each rule leads to model-implied UIP violations, which we derive analytically and then calibrate numerically. Our key finding is that only a forward-looking rule based on CPI inflation can account for frequently observed strong UIP violations.

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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 396.

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Length: 42 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:bis:biswps:396
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  2. Charles Engel & Kenneth D. West, 2003. "Exchange rates and fundamentals," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  4. 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.
  5. Timothy J. Kehoe & Kim J. Ruhl, 2008. "Are Shocks to the Terms of Trade Shocks to Productivity?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 804-819, October.
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  7. Adrien Verdelhan & Hanno Lustig, 2005. "The Cross-Section Of Foreign Currency Risk Premia And Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2005-019, Boston University - Department of Economics.
  8. Philippe Bacchetta & Eric van Wincoop, 2007. "Random Walk Expectations and the Forward Discount Puzzle," Working Papers 07.01, Swiss National Bank, Study Center Gerzensee.
  9. Kenneth S. Rogoff & Vania Stavrakeva, 2008. "The Continuing Puzzle of Short Horizon Exchange Rate Forecasting," NBER Working Papers 14071, National Bureau of Economic Research, Inc.
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  11. Engel, Charles & West, Kenneth D., 2006. "Taylor Rules and the Deutschmark: Dollar Real Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1175-1194, August.
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  13. Douglas Laxton & Paolo Pesenti, 2003. "Monetary Rules for Small, Open, Emerging Economies," NBER Working Papers 9568, National Bureau of Economic Research, Inc.
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  15. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  16. 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.
  17. Benigno, Gianluca, 2004. "Real exchange rate persistence and monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 473-502, April.
  18. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
  19. Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2008. "High exchange-rate volatility and low pass-through," Journal of Monetary Economics, Elsevier, vol. 55(6), pages 1113-1128, September.
  20. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  21. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  22. Philippe Bacchetta & Eric van Wincoop, 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 100(3), pages 870-904, June.
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