Monetary Policy and the Uncovered Interest Rate Parity Puzzle

Backus, David; Gavazzoni, Federico; Telmer, Chris; Zin, Stanley E.

doi:10.2139/ssrn.1634825

Cited by 14 publications

(41 citation statements)

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“…The UIP evidence is related to short-term interest rates and currency depreciation rates. Because monetary policy influences short-term interest rates in the case of an IRR or nominal exchange rates in the case of an ERR, the UIP puzzle can be formulated in terms of monetary policy (Backus et al, 2010). A traditional open economy model cannot replicate the forward premium anomaly as it typically assumes that UIP holds.…”

Section: Theorymentioning

confidence: 99%

“…a risk premium that generates a wedge between the interest rate differential and the expected exchange rate depreciation (Alvarez, Atkeson, and Kehoe, 2009;Backus et al, 2010;Benigno, Benigno, and Nisticò, 2013;and Verdelhan, 2010, among others). The risk premium interpretation of the UIP puzzle asserts that high interest rate currencies pay positive risk premiums.…”

Section: Santacreumentioning

confidence: 99%

“…To answer this question, I derive an analytical solution for the foreign exchange risk premium as a function of the monetary rule parameters for both an IRR and an ERR. I follow the procedure described by Backus et al (2010) for an endowment economy with complete markets but with one modification: Instead of using recursive preferences, I assume there is external habit in the utility function (as in Verdelhan, 2010). External habit formation, also known as "catching up with the Joneses" (Abel, 1990), simplifies the consumer's optimization problem because the evolution of the stock of habit is taken as exogenous by the consumer.…”

Section: Santacreumentioning

confidence: 99%

“…To derive an analytical solution for the risk premium, I follow Backus et al (2010) and use the method of undetermined coefficients; they assume that inflation follows a particular functional form. Then, using the first-order conditions, the international risk-sharing condition, and the expression for the corresponding rule, I obtain an expression for the risk premium that can be expressed as …”

Section: Santacreumentioning

confidence: 99%

See 3 more Smart Citations

Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Santacreu

2015

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Section: Theorymentioning

confidence: 99%

Section: Santacreumentioning

confidence: 99%

Section: Santacreumentioning

confidence: 99%

Section: Santacreumentioning

confidence: 99%

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Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Santacreu

2015

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“…McCallum (1994) recognises that interest rate smoothing by the central bank can successfully explain the widely reported empirical failure of the UIP hypothesis. 2 Employing an optimising two-country framework, Backus et al (2010) show the inverse link between the interest rate differential and the change in the nominal exchange rate to be the result of the domestic central bank ignoring exchange rate movements in setting the policy instrument. Paradoxically, the foreign central bank must tighten monetary policy in response to its currency appreciating for the negative association of the interest rate differential with the change in the nominal exchange rate to hold.…”

Section: Introductionmentioning

confidence: 99%

Monetary Policy and the Uncovered Interest Rate Parity Puzzle: Theory and Empirical Results for Oceania

Guender

2014

Economic Record

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This article offers a theory-based explanation for why highinterest-rate countries see their currencies appreciate, the so-called UIP puzzle. The central bank bases its target rule on the lag of the policy instrument and the CPI inflation rate. When combined with a stylised model of an open economy, the endogenous target rule can account for the systematic negative relation between the change in the exchange rate and the lagged interest rate differential. Foreign inflation and the foreign interest rate also affect nominal exchange rate changes. The model-based behaviour of the exchange rate is tested on New Zealand and Australian data with mixed results. I IntroductionAbsent any risk premium, the uncovered interest rate parity (UIP) hypothesis suggests that a positive interest rate differential (domestic interest rate minus foreign interest rate) should be compensated in full by a depreciation of the domestic currency over the term to maturity of the underlying short-term financial asset. In practice, the presumed one-for-one relationship between the interest rate differential and the expected change in the nominal exchange rate is not apparent in the data. In fact, many studies report a negative association between movements in the interest rate differential and observed changes in the nominal exchange rate. The observed violation of the UIP condition has been labelled the 'UIP Puzzle'. focus exclusively on whether uncovered interest rate parity holds between New Zealand and Australia over the 198-2008 (July) sample period. Their empirical study excludes the immediate period after the float of the Kiwi dollar as well as the peak and aftermath of the Global Financial Crisis. Following the standard atheoretical testing procedure, which relies on regressing the realised change in the nominal exchange rate on the lagged interest rate differential, they investigate whether UIP holds over the short term (90-day horizon) and over the long term (five-year and 10-year horizon, respectively). They find no evidence in favour of the UIP hypothesis over a short horizon. Over longer horizons the evidence is mixed with a 10-year horizon providing the strongest support for the theory. Burnside (2013) explores the role of New Zealand's risk premium as a factor in the country's imbalances. In this context, he also examines whether UIP holds between New Zealand and various other countries, Australia being one of them. He detects a positive yet statistically insignificant link between NZ and AUS dollar exchange rate movements and interest rate differentials over the 1990-2010 period and interprets this as evidence in favour of the UIP hypothesis. 207

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The Risk Premium, Interest Rate Determination, and Monetary Independence Under a Fixed, but Adjustable, Exchange Rate

Pasula

2016

Int. J Fin Econ

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This paper examines interest rate determination and monetary independence in a small economy with a fixed exchange rate. The risk premium is determined endogenously in the stochastic, general-equilibrium model. The sign of the risk premium and the magnitude of the interest rate depend on the specification of the policy rule for the future exchange rate. Increases in domestic credit can decrease, increase or have no effect on the interest rate. The offset coefficient can differ from À1 (the 'trilemma' may not hold), but numerical calculations indicate that the offset is close to À1. Under certain conditions, empirical analyses overestimate monetary independence.

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Monetary Policy and the Uncovered Interest Rate Parity Puzzle

Cited by 14 publications

References 11 publications

Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules

Monetary Policy and the Uncovered Interest Rate Parity Puzzle: Theory and Empirical Results for Oceania

The Risk Premium, Interest Rate Determination, and Monetary Independence Under a Fixed, but Adjustable, Exchange Rate

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