Abstract
Uncovered interest parity is widely used in open economy macroeconomics. But when exchange rates are flexible the evidence rejects UIP and implies forward bias. There are many suggested explanations for this failure of UIP and forward bias, but none are widely accepted, at least partially because none appear to explain the related puzzles discussed below. This article shows how sterilized “leaning against the wind” and a combination of the inflationary and liquidity effects associated with open market operations can explain forward bias and the failure of UIP even when expectations are rational. They also appear to be able to explain the related puzzles.
Highlights
As [1] points out, uncovered interest parity (UIP) is one of three key international financial relations used repeatedly in open-economy macroeconomics
Uncovered interest parity is widely used in open economy macroeconomics
This article shows how sterilized “leaning against the wind” and a combination of the inflationary and liquidity effects associated with open market operations can explain forward bias and the failure of UIP even when expectations are rational
Summary
As [1] points out, uncovered interest parity (UIP) is one of three key international financial relations used repeatedly in open-economy macroeconomics. The importance of forward bias and the failure of UIP have prompted many attempts to explain them, but none has distinguished between flexible and managed exchange rates. The puzzle as to why the two theories fail so badly under flexible rates, but not managed rates, remains All these explanations, including the one proposed here, were developed to explain forward bias and/or the failure of UIP. They are 1) the Carry Trade Puzzle, 2) the Commodity Puzzle, 3) the Development Puzzle, 4) the Inflation and Outlier Puzzles, 5) the Maturity Puzzle and 6) the Time Dependency Puzzle Explaining these puzzles would support explanations for forward bias and the failure of UIP. It reviews the evidence for managed exchange rates.
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