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The Extrapolative Component in Exchange Rate Expectations and the Not-So-Puzzling Interest Parity: The Case of Uruguay

Author

Listed:
  • Gonzalo Varela

    (Department of Economics, University of Sussex)

Abstract

This paper analyses the importance attached to the past behaviour of the exchange rate when forming expectations and tests for the uncovered interest parity hypothesis. Using interest rate di erentials for Uruguay over 1980-2010, we identify a strong and time-varying extrapolative component in exchange rate expectations. Agents attach more importance to the past behaviour of exchange rates the higher the level of in ation is. Yet agents are able to internalise policy announcements and external events that are likely to a ect exchange rate fun- damentals. Further, we nd deviations from the uncovered interest parity hy- pothesis. These are lower than those usually reported for developed economies. Also, they tend to be higher for the period of low in ation and freely oating exchange rates. As long as what it takes to predict well is rather simple | i.e. look backwards, follow policy announcements, the interest rate di erential per- forms well. Once the exchange rate determination model becomes more intricate or less familiar to the agents, they tend to fail at predicting exchange rate depre- ciations. These results point to expectational failures as a likely explanation for the `uncovered interest parity puzzle'.

Suggested Citation

  • Gonzalo Varela, 2011. "The Extrapolative Component in Exchange Rate Expectations and the Not-So-Puzzling Interest Parity: The Case of Uruguay," Working Paper Series 1911, Department of Economics, University of Sussex Business School.
    • Handle: RePEc:sus:susewp:1911
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    File URL: http://www.sussex.ac.uk/economics/documents/wps19-2011-gvarela.pdf
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    More about this item

    Keywords

    Exchange rates; Uncovered interest parity; Expectations; Emerging Economies; Bias; Puzzle;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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