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For about three decades until the Global Financial Crisis (GFC), Covered Interest Parity (CIP) appeared to hold quite closely—even as a broad macroeconomic relationship applying to daily or weekly data. Not only have CIP deviations significantly increased since the GFC, but potential macrofinancial drivers of the variation in CIP deviations have also become significant. The variation in CIP deviations seems to be associated with multiple factors, not only regulatory changes. Most of these do not display a uniform importance across currency pairs and time, and some are associated with possible temporary considerations (such as asynchronous monetary policy cycles).
This note provides an overview of the uncovered interest parity assumption. It traces the history of the interest parity concept, summarizes evidence on the empirical validity of uncovered interest parity, and discusses the implications for macroeconomic analysis. The uncovered interest parity assumption has been an important building block in multiperiod and continuous time models of open economies, and although its validity is strongly challenged by the empirical evidence, its retention in macroeconomic models is supported on pragmatic grounds, at least for the time being, by the lack of much empirical support for existing models of the exchange risk premium.
Uncovered interest parity (UIP) has been almost universally rejected in studies of exchange rate movements, although there is little consensus on why it fails. In contrast to previous studies, which have used relatively short-horizon data, we test UIP using interest rates on longer-maturity bonds for the G-7 countries. These long-horizon regressions yield much more support for UIP -- all the coefficients on interest differentials are of the correct sign, and almost all are closer to the UIP value of unity than to the zero coefficient implied by the random walk hypothesis. We then use a small macroeconomic model to explain the differences between the short- and long-horizon results. Regressions run on data generated by stochastic simulations replicate the important regularities in the actual data, including the sharp differences between short- and long-horizon parameters. In the short run from risk premium shocks in the face of endogenous monetary policy. In the long run, in contrast, exchange rate movements are driven by the "fundamentals," leading to a relationship between interest rates and exchange rates that is more consistent with UIP.
This comprehensive Handbook deftly examines key aspects of financial integration, providing an overview of contemporary research and new perspectives. Employing state of the art econometric methods to obtain new empirical evidence, it will be critical for designing optimal policies, and appropriate investment and risk management strategies.
The Monetary Authority of Singapore, Asian Bureau of Finance and Economic Research, University of Chicago Booth Business School, and National University of Singapore Business School have organised the Asian Monetary Policy Forum (AMPF) annually since 2014. The Forum brings together eminent academics, policymakers and private sector economists to deliberate pressing monetary policy issues particularly relevant for Asian countries.This volume collects the inaugural speech and commissioned papers from the past Forums from 2014 to 2020. The chapters cover a range of topics that have assumed importance in the global monetary and financial system over the past twenty years. These include the efficacy of traditional monetary policy frameworks amid synchronised global financial flows, the challenges presented by the US dollar dominance, and the optimality of central banks' use of a broader set of policy instruments within an integrated policy framework. Policymakers, practitioners, students and academicians will be able to draw from this volume useful insights to understand these complex policy challenges.
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Praise for Handbook of Exchange Rates “This book is remarkable. I expect it to become the anchor reference for people working in the foreign exchange field.” —Richard K. Lyons, Dean and Professor of Finance, Haas School of Business, University of California Berkeley “It is quite easily the most wide ranging treaty of expertise on the forex market I have ever come across. I will be keeping a copy close to my fingertips.” —Jim O’Neill, Chairman, Goldman Sachs Asset Management How should we evaluate the forecasting power of models? What are appropriate loss functions for major market participants? Is the exchange rate the only means of adjustment? Handbook of Exchange Rates answers these questions and many more, equipping readers with the relevant concepts and policies for working in today’s international economic climate. Featuring contributions written by leading specialists from the global financial arena, this handbook provides a collection of original ideas on foreign exchange (FX) rates in four succinct sections: • Overview introduces the history of the FX market and exchange rate regimes, discussing key instruments in the trading environment as well as macro and micro approaches to FX determination. • Exchange Rate Models and Methods focuses on forecasting exchange rates, featuring methodological contributions on the statistical methods for evaluating forecast performance, parity relationships, fair value models, and flow–based models. • FX Markets and Products outlines active currency management, currency hedging, hedge accounting; high frequency and algorithmic trading in FX; and FX strategy-based products. • FX Markets and Policy explores the current policies in place in global markets and presents a framework for analyzing financial crises. Throughout the book, topics are explored in-depth alongside their founding principles. Each chapter uses real-world examples from the financial industry and concludes with a summary that outlines key points and concepts. Handbook of Exchange Rates is an essential reference for fund managers and investors as well as practitioners and researchers working in finance, banking, business, and econometrics. The book also serves as a valuable supplement for courses on economics, business, and international finance at the upper-undergraduate and graduate levels.
The growing levels of income inequality, an explosion of global financial flows, and a worldwide decline of economic growth have combined to challenge accepted economic wisdom. Utilizing a heterodox approach, Pablo G. Bortz provides a fresh look for understanding the interaction between these three factors while identifying challenges and possible alternatives for an expansionary and progressive economic policy. Reviewing several schools of thought, Inequality, Growth and ‘Hot’ Money explores the risks generated by capital flows and the limitations they impose on progressive economic policies. Professor Bortz then provides instruments and alternatives to pursue an expansionary and equalitarian program, including theoretical contributions to enrich heterodox and progressive economics. Standout features of this book include a review of the challenges that financial flows pose for developing countries; a redefinition of the role of capital controls; a policy approach that separates interest rate policies from a broader credit policy; and a rejection of the negative relationship between a more egalitarian income distribution and sustained economic expansion. Expanding the Kaleckian approach to include financial flows, this accessible introduction to heterodox growth models will be appreciated by graduate students and committed heterodox economists. Research departments at official institutions such as central banks may also be interested, specifically in the book’s models and policy prescription.
This paper tests uncovered interest parity (UIP) using interest rates on longer maturity bonds for the Group of Seven countries. These long-horizon regressions yield much more support for UIP—all of the coefficients on interest differentials are of the correct sign, and almost all are closer to the UIP value of unity than to zero. The paper also analyzes the decision by a government facing electoral uncertainty to implement structural reforms in the presence of fiscal restraints similar to the Stability and Growth Pact.