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For Rich or for Poor: When does Uncovered Interest Parity Hold?

  • Maurice J. Roche

    ()

    (Department of Economics, Ryerson University, Toronto, Canada)

  • Michael J. Moore

    ()

    (School of Management and Economics, The Queen's University of Belfast, Belfast, Northern Ireland)

We present a model that simultaneously explains why uncovered interest parity holds for some pairs of countries and not for others. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The negative slope in the Fama regression arises when monetary instability is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary instability is high, the Fama slope is positive in line with uncovered interest parity. The model is simulated using the artificial economy methodology for 34 currencies against the US dollar. We conclude that, given the predominance of precautionary savings, the degree of monetary instability explains whether or not uncovered interest parity holds.

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Paper provided by Ryerson University, Department of Economics in its series Working Papers with number 015.

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Length: 29 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:rye:wpaper:wp015
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  1. Ravn, Morten O & Schmitt-Grohé, Stephanie & Uribe, Martín, 2007. "Pricing to Habits and the Law of One Price," CEPR Discussion Papers 6030, C.E.P.R. Discussion Papers.
  2. Maurice J. Roche & Michael J. Moore, . "Less of a puzzle: a new look at the forward forex market," Economics, Finance and Accounting Department Working Paper Series n, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  3. Morten Ravn & Stephanie Schmitt-Grohé & Mart�n Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
  4. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
  5. Maurice J. Roche & Michael J. Moore, 2007. "Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs," Economics, Finance and Accounting Department Working Paper Series n1750507, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  6. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sérgio, 2007. "Understanding the Forward Premium Puzzle: A Microstructure Approach," CEPR Discussion Papers 6399, C.E.P.R. Discussion Papers.
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  8. Abel, Andrew B, 1990. "Asset Prices under Habit Formation and Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 80(2), pages 38-42, May.
  9. Eric O'N. Fisher, 2000. "The Forward Premium in a Model with Heterogeneous Prior Beliefs," Working Papers 01-05, Ohio State University, Department of Economics.
  10. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
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  13. Paul De Grauwe (ed.), 2005. "Exchange Rate Economics: Where Do We Stand?," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262042223, June.
  14. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.
  15. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 277, Federal Reserve Bank of Minneapolis.
  16. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  17. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  18. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  19. Hiro Ito & Menzie Chinn, 2007. "Price-Based Measurement Of Financial Globalization: A Cross-Country Study Of Interest Rate Parity," Pacific Economic Review, Wiley Blackwell, vol. 12(4), pages 419-444, October.
  20. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
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