We present a model that simultaneously explains why uncovered interest parity holds for some pairs of countries and not for others. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The negative slope in the Fama regression arises when monetary instability is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary instability is high, the Fama slope is positive in line with uncovered interest parity. The model is simulated using the artificial economy methodology for 34 currencies against the US dollar. We conclude that, given the predominance of precautionary savings, the degree of monetary instability explains whether or not uncovered interest parity holds.
Eichenbaum (2008) investigates equally weighted carry trade portfolios for 20 portfolios over a thirty year period and finds consistent excess dollar returns. A ‘carry trade portfolio’ is a strategy of borrowing in the currency of the low interest currency and depositing the proceeds in the high interest currency, taking an open position to nominal exchange rate risk. He concludes that this vividly demonstrates the pervasiveness of the forward ‘bias’ puzzle. The contribution of this study is to specify and test a theory which provides for when the forward bias does and does not hold.
The literature that studies this puzzle or equivalently the failure of uncovered interest parity (UIP) is enormous. The classic survey is Engel (1996) and Sarno (2005) contains a good update. There is a multitude of relatively recent theoretical papers which explain the failure of uncovered interest parity. There are behavioural explanations (Burnside, Eichenbaum and Rebelo, 2007, Fisher, 2006 and Gourinchas and Tornell, 2004); rational inattention is offered by Bachetta and Van Wincoop (2008); institutional features are emphasised by Carlson and Osler (2005); and Alvarez, Atkinson and Kehoe (2006) explain the forward bias by permitting a time varying degree of asset market participation. Bansal and Shaliastovich (2007) extend the Bansal and Yaron (2004) model to explain the forward bias using Epstein-Zin preferences, long-run growth fluctuations and time-varying uncertainty. In a model related to the one explored in this paper, Verdelhan (2010) attempts to explain the forward bias puzzle using Campbell and Cochrane (1999) preferences in a non-monetary economy with trade costs. It is difficult to interpret this work because real interest rates cannot be observed so that it is not clear if there is a real analogue to the forward bias problem in the data. Moore and Roche (2007) show that the Verdelhan (2010) result can be obtained as a special case of our analysis, without the contrivance of trade costs.
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For Rich or for Poor: When does Uncovered Interest Parity Hold?
