International Evidence on the Role of Monetary Policy in the Uncovered Interest Rate Parity Puzzle (2015)
Type of ContentConference Contributions - Published
PublisherUniversity of Canterbury. Department of Economics and Finance
CPI inflation targeting necessitates a flexible exchange rate regime. This paper embeds an endogenous target rule into a simple open economy macro model to explain the UIP puzzle. The model predicts that the change in the exchange rate is inversely related to the lagged interest rate differential. Openness and aversion to inflation variability determine the strength of this linkage. Foreign inflation and the foreign interest rate also affect exchange rate changes. This hypothesis is tested on data from three small open economies, Canada, Norway, and Switzerland, all of which target CPI inflation and maintain extensive trade and finance links with a larger neighboring country. Supportive evidence is strongest for Switzerland during a clean float period before the outbreak of the Global Financial Crisis.
CitationGuender, A.V. (2015) International Evidence on the Role of Monetary Policy in the Uncovered Interest Rate Parity Puzzle. Honolulu, HI, USA: 90th Annual Conference of the Western Economic Association International, 28 Jun-2 Jul 2015.
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KeywordsUncovered Interest Rate Parity (UIP) Puzzle; Target Rule; Optimal Monetary Policy; Openness; Aversion to Inflation Variability
ANZSRC Fields of Research14 - Economics::1402 - Applied Economics::140210 - International Economics and International Finance
38 - Economics::3801 - Applied economics::380112 - Macroeconomics (incl. monetary and fiscal theory)
35 - Commerce, management, tourism and services::3502 - Banking, finance and investment::350203 - Financial econometrics
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Guender, A.V. (College of Business and EconomicsUniversity of Canterbury. Department of Economics and Finance, 2011)Employing an optimizing framework, this paper shows that a target rule dominates a simple instrument rule when the focus of monetary policy is on CPI inflation. The target rule approach produces a systematic relationship ...
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