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Can Endogenous Monetary Policy Explain the Deviations from UIP

  • Alexius, Annika

    (Department of Economics)

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.

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Paper provided by Uppsala University, Department of Economics in its series Working Paper Series with number 2002:17.

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Length: 34 pages
Date of creation: 15 Aug 2002
Date of revision:
Handle: RePEc:hhs:uunewp:2002_017
Contact details of provider: Postal: Department of Economics, Uppsala University, P. O. Box 513, SE-751 20 Uppsala, Sweden
Phone: + 46 18 471 25 00
Fax: + 46 18 471 14 78
Web page: http://www.nek.uu.se/
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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. Ronald Macdonald & Mark P. Taylor, 1992. "Exchange Rate Economics: A Survey," IMF Staff Papers, Palgrave Macmillan, vol. 39(1), pages 1-57, March.
  3. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
  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. Hodrick, Robert J. & Srivastava, Sanjay, 1986. "The covariation of risk premiums and expected future spot exchange rates," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages S5-S21, March.
  6. Alexius, Annika & Sellin, Peter, 1997. "A Latent Factor Model of European Exchange Rate Risk Premia," SSE/EFI Working Paper Series in Economics and Finance 156, Stockholm School of Economics.
  7. Svensson, L.E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Papers 646, Stockholm - International Economic Studies.
  8. Svensson, L.E.O., 1998. "Open-Economy Inflation Targeting," Papers 638, Stockholm - International Economic Studies.
  9. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters, in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
  10. Robert J. Hodrick, 1987. "Risk, Uncertainty and Exchange Rates," NBER Working Papers 2429, National Bureau of Economic Research, Inc.
  11. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
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  13. Orphanides, Athanasios & Wieland, Volker, 1999. "Inflation zone targeting," Working Paper Series 0008, European Central Bank.
  14. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
  15. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  16. Gilles Oudiz & Jeffrey Sachs, 1985. "International Policy Coordination in Dynamic Macroeconomic Models," NBER Chapters, in: International Economic Policy Coordination, pages 274-330 National Bureau of Economic Research, Inc.
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  18. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  19. Alexius, Annika, 2000. "UIP for Short Investments in Long-Term Bonds," Working Paper Series 115, Sveriges Riksbank (Central Bank of Sweden).
  20. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
  21. 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.
  22. 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.
  23. Froot, Kenneth A. & Frankel, Jeffrey A., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Department of Economics, Working Paper Series qt5w65g4zg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  24. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
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