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Can Endogenous Monetary Policy Explain the Deviations from UIP

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  • Alexius, Annika

    (Department of Economics)

Abstract

The co-movements of nominal exchange rates and short-term interest rates as the economy is hit by shocks is a potential source of ex post deviations from uncovered interest rate parity. This paper investigates whether an established model of endogenous monetary policy in an open economy is capable of explaning the exchange rate risk premium puzzle. Time series on interest differentials and exchange rate changes are generated from the Svensson (2000) model. Uncovered interest rate parity is tested on the simulated data and the b-coefficients are investigated. For most realistic choices of parameter values, the b-coefficients are positive but much smaller than the unity value expected from UIP. It is however also possible to obtain large, negative b-coefficients if the central bank is engaged in interest rate smoothing.

Suggested Citation

  • Alexius, Annika, 2002. "Can Endogenous Monetary Policy Explain the Deviations from UIP," Working Paper Series 2002:17, Uppsala University, Department of Economics.
  • Handle: RePEc:hhs:uunewp:2002_017
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Alexius, Annika & Sellin, Peter, 1999. "A Latent Factor Model of European Exchange Rate Risk Premia," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 4(3), pages 217-227, July.
    3. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
    4. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    5. Kenneth A. Froot & Jeffrey A. Frankel, 1989. "Forward Discount Bias: Is it an Exchange Risk Premium?," The Quarterly Journal of Economics, Oxford University Press, vol. 104(1), pages 139-161.
    6. Robert P. Flood & Mark P. Taylor, 1996. "Exchange Rate Economics: What's Wrong with the Conventional Macro Approach?," NBER Chapters,in: The Microstructure of Foreign Exchange Markets, pages 261-302 National Bureau of Economic Research, Inc.
    7. Svensson, Lars E. O., 1999. "Inflation targeting as a monetary policy rule," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 607-654, June.
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    Cited by:

    1. Carlo A. Favero & Francesco Giavazzi, 2004. "Inflation Targeting and Debt: Lessons from Brazil," NBER Working Papers 10390, National Bureau of Economic Research, Inc.
    2. Alex Luiz Ferreira, 2015. "The Simultaneity Bias of the Uncovered Interest Rate Parity: evidence using survey data for Brazil," Economics Bulletin, AccessEcon, vol. 35(3), pages 1718-1725.
    3. Alex Luiz Ferreira, 2008. "The Simultaneity Bias of the Uncovered Interest Rate Parity: Evidence for Brazil," Working Papers 08_20, Universidade de São Paulo, Faculdade de Economia, Administração e Contabilidade de Ribeirão Preto.
    4. Gottfries, Nils, 2003. "Booms and Busts in EMU," Working Paper Series 2003:29, Uppsala University, Department of Economics.

    More about this item

    Keywords

    Monetary policy; Uncovered interest parity; Exchange rate risk premium;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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