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A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

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  • Jung, Kuk Mo
  • Lee, Seungduck

Abstract

A new monetary theory is set out to resolve the “Uncovered Interest Parity Puzzle (UIP Puzzle)”. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premium due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage condition ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory in fact has interesting implications on many empirical observations that risk based explanations find difficult to reconcile with.

Suggested Citation

  • Jung, Kuk Mo & Lee, Seungduck, 2015. "A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle," MPRA Paper 64164, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:64164
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 74010, University Library of Munich, Germany.
    2. Athanasios Geromichalos & Kuk Mo Jung, 2014. "An Over-the-Counter Approach to the FOREX Market," Working Papers 144, University of California, Davis, Department of Economics.
    3. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 73707, University Library of Munich, Germany.
    4. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 73533, University Library of Munich, Germany.
    5. Herrenbrueck, Lucas & Geromichalos, Athanasios, 2017. "A tractable model of indirect asset liquidity," Journal of Economic Theory, Elsevier, vol. 168(C), pages 252-260.
    6. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 74615, University Library of Munich, Germany.
    7. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 75869, University Library of Munich, Germany.
    8. Athanasios Geromichalos & Jiwon Lee & Seungduck Lee & Keita Oikawa, 2016. "Over-the-counter trade and the value of assets as collateral," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 443-475, August.
    9. Liu, Tao, 2016. "Trade finance and international currency: a moneatary search approach," MPRA Paper 68834, University Library of Munich, Germany.

    More about this item

    Keywords

    uncovered interest parity puzzle; monetary search models; FOREX market;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • 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

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