Monetary Policy and the Uncovered Interest Rate Parity Puzzle

72 Pages Posted: 6 Jul 2010 Last revised: 14 Aug 2013

David K. Backus

NYU Stern School of Business; National Bureau of Economic Research (NBER)

Federico Gavazzoni

INSEAD

Chris Telmer

Carnegie Mellon University - David A. Tepper School of Business

Stanley E. Zin

New York University (NYU); National Bureau of Economic Research (NBER)

Date Written: March 1, 2013

Abstract

High interest rate currencies tend to appreciate. This is the uncovered interest rate parity (UIP) puzzle. It is primarily a statement about short-term interest rates and how they are related to exchange rates. Short-term interest rates are strongly affected by monetary policy. The UIP puzzle, therefore, can be restated in terms of monetary policy. Do foreign and domestic monetary policies imply exchange rates that violate UIP? We represent monetary policy as foreign and domestic Taylor rules. Foreign and domestic pricing kernels determine the relationship between these Taylor rules and exchange rates. We examine different specifications for the Taylor rule and ask which can resolve the UIP puzzle. We find evidence in favor of a particular asymmetry. If the foreign Taylor rule responds to exchange rate variation but the domestic Taylor rule does not, the model performs better. A calibrated version of our model is consistent with many empirical observations on real and nominal exchange rates, including Fama-84 negative correlation between interest rate differentials and currency depreciation rates.

Keywords: Uncovered interest parity, carry trade, exchange rates, Taylor rule

JEL Classification: E44, E58, F31, G12

Suggested Citation

Backus, David K. and Gavazzoni, Federico and Telmer, Chris and Zin, Stanley E., Monetary Policy and the Uncovered Interest Rate Parity Puzzle (March 1, 2013). Available at SSRN: https://ssrn.com/abstract=1634825 or http://dx.doi.org/10.2139/ssrn.1634825

David K. Backus

NYU Stern School of Business

44 West Fourth Street
New York, NY 10012
United States
212-998-0873 (Phone)
212-995-4220 (Fax)

HOME PAGE: http://pages.stern.nyu.edu/~dbackus/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

HOME PAGE: http://pages.stern.nyu.edu/~dbackus/

Federico Gavazzoni

INSEAD ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

HOME PAGE: http://federicogavazzoni.com

Christopher I. Telmer (Contact Author)

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-8838 (Phone)
(412) 268-6837 (Fax)

Stanley E. Zin

New York University (NYU) ( email )

Bobst Library, E-resource Acquisitions
20 Cooper Square 3rd Floor
New York, NY 10003-711
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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