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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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  19. Galí, Jordi & Monacelli, Tommaso, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," CEPR Discussion Papers 3346, C.E.P.R. Discussion Papers.
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