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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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    Cited by:

    1. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 74010, University Library of Munich, Germany.
    2. Altermatt, Lukas & Iwasaki, Kohei & Wright, Randall, 2021. "Asset pricing in monetary economies," Journal of International Money and Finance, Elsevier, vol. 115(C).
    3. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 73533, University Library of Munich, Germany.
    4. Herrenbrueck, Lucas & Geromichalos, Athanasios, 2017. "A tractable model of indirect asset liquidity," Journal of Economic Theory, Elsevier, vol. 168(C), pages 252-260.
    5. 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.
    6. Herrenbrueck, Lucas & Geromichalos, Athanasios, 2017. "A tractable model of indirect asset liquidity," Journal of Economic Theory, Elsevier, vol. 168(C), pages 252-260.
    7. Jung, Kuk Mo & Pyun, Ju Hyun, 2016. "International reserves for emerging economies: A liquidity approach," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 230-257.
    8. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 73707, University Library of Munich, Germany.
    9. Seungduck Lee, 2020. "Money, Asset Prices, and the Liquidity Premium," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(6), pages 1435-1466, September.
    10. Athanasios Geromichalos & Kuk Mo Jung, 2014. "An Over-the-Counter Approach to the FOREX Market," Working Papers 156, University of California, Davis, Department of Economics.
    11. Liu, Tao & Lu, Dong & Woo, Wing Thye, 2019. "Trade, finance and international currency," Journal of Economic Behavior & Organization, Elsevier, vol. 164(C), pages 374-413.
    12. Athanasios Geromichalos & Kuk Mo Jung & Seungduck Lee & Dillon Carlos, 2019. "Asset Liquidity in Monetary Theory and Finance: A Unified Approach," Working Papers 1905, Research Institute for Market Economy, Sogang University.
    13. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 74615, University Library of Munich, Germany.
    14. Lee, Seungduck, 2016. "Money, Asset Prices and the Liquidity Premium," MPRA Paper 75869, University Library of Munich, Germany.
    15. Lucas Herrenbrueck, 2019. "Interest Rates, Moneyness, and the Fisher Equation," Discussion Papers dp19-01, Department of Economics, Simon Fraser University.
    16. Liu, Tao, 2016. "Trade finance and international currency: a moneatary search approach," MPRA Paper 68834, University Library of Munich, Germany.
    17. Geromichalos, Athanasios & Jung, Kuk Mo & Lee, Seungduck & Carlos, Dillon, 2021. "A model of endogenous direct and indirect asset liquidity," European Economic Review, Elsevier, vol. 132(C).

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    More about this item

    Keywords

    uncovered interest parity puzzle; monetary search models; FOREX market;
    All these keywords.

    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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