SEMINAR 21 May 2012: Demosthenes Tambakis, University of Cambridge

Systematic Monetary Policy and the Forward Premium Puzzle

Abstract

We investigate whether systematic monetary policy is behind the forward premium puzzle, i.e. the tendency of high interest-rate currencies to appreciate, thus violating Uncovered Interest Parity (UIP). We consider a battery of monetary policy rules, which target strictly or react to either domestic or CPI inflation, in an economy influenced by both domestic and foreign shocks. Each rule has specific implications for UIP violation, which we derive explicitly and compare to empirical results. We find that most of the policy rules can account for instances of weak UIP violations in the data. However, only a forward-looking CPI rule can approximate the magnitude of frequently observed extreme UIP violations.

 Keywords: Monetary policy rules, uncovered interest parity, exchange rate dynamics, currency-risk.

 JEL classification codes: E52, E58, F33