An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle

Abstract

A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a timevarying risk premium. This paper presents a mechanism in a simple two-country two-good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents' strong resulting precautionary motives successfully generates a time-varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.

Determinants of fiscal multipliers revisited

“…We iterate on guesses of the conditional expectation appearing in the Euler equation, and in the two auxiliary equations of the Calvo price setting problem. The algorithm is layed out in detail in Rabitsch (2012Rabitsch ( , 2016. Tables 5 and 6 shock that puts the economy into a ZLB is such that output drops by about 30 percent -the table also reports the size of the ZLB-shock, and the implied drops in output and (annualized) inflation in percent.…”

US Shocks and the Uncovered Interest Rate Parity

“…where i indicates a currency pair against US dollars. Understandably, l t is closely related to US monetary policy, especially in the short-term (Taylor, 2001;Gagnon and Ihrig, 2004;Backus et al, 2013), productivity (Corsetti et al, 2008;Rabitsch, 2016) and consumption growth (Lustig and Verdelhan, 2007;Lustig et al, 2014). Through international channels including monetary policy coordination (Edwards, 2015;Bruno and Shin, 2015) and foreign direct investment (Klein and Rosengren, 1994;Barrell and Pain, 1996), the bilateral interest rate differential d i,t is correlated with l t , biasing least squares estimates of UIP coefficients (or estimates from Kalman filter in a TVC model).…”

“…Many papers show that there exist some common factors driving the currency risk premium (see e.g. Taylor, 2001; Gagnon and Ihrig, 2004;Backus et al, 2013;Corsetti et al, 2008;Rabitsch, 2016;Lustig and Verdelhan, 2007;Lustig et al, 2014), thus affect movements of UIP coefficients. We make explicit these driving forces by letting US shocks partially lead the local movements of coefficients.…”