Breaking the UIP: A Model-Equivalence Result

Yakhin, Yossi (2019): Breaking the UIP: A Model-Equivalence Result.

Abstract

Breaking the uncovered interest rate parity (UIP) condition is essential to accounting for the empirical behavior of exchange rates, and is a prerequisite for theoretical analysis of sterilized foreign exchange interventions. Gabaix and Maggiori (2015) account for some of the long-standing empirical exchange rate puzzles by introducing financial intermediaries that are willing to absorb international saving imbalances for a premium, thereby deviating from the UIP. In another important contribution, Fanelli and Straub (2019) lay down the principles for foreign exchange interventions. In their model, regulatory exposure limits and participation cost in the international financial markets drive a wedge in the UIP. This paper demonstrates that, to a first order approximation, these models are equivalent to a reduced-form portfolio adjustment cost model, as in Schmitt-Grohé and Uribe (2003). Therefore, to the extent that one is only concerned with first-order dynamics and second moments, there is no gain from adopting the rich microstructure of either models -- a simple portfolio adjustment cost is just as good.

• Item Type: MPRA Paper
• Language: English
• Keywords: UIP; Financial Frictions; Open Economy Macroeconomics
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Alla, Z., Espinoza, R. A., Gosh, A. R., 2017. "FX Intervention in the New Keynesian Model." International Monetary Fund Working Paper WP/17/207.

Alvarez, F., Atkeson, A., Kehoe, P. J., 2009. "Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium." The Review of Economic Studies 76(3), pp. 851-878.

Amisano, G., Tristani, O., 2010. "Euro Area Inflation Persistence in An Estimated Nonlinear DSGE Model." Journal of Economic Dynamics and Control 34(10), pp. 1837-1858.

Backus, D. K., Kehoe, P. J., 1989. "On the Denomination of Government Debt: A Critique of the Portfolio Balance Approach." Journal of Monetary Economics 23(3), pp. 359--376.

Benes, J., Berg, A., Portillo, R. A., Vavra, D., 2015. "Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework." Open Economy Review 26(1), pp. 81-108.

Cavallino, P., 2019. "Capital Flows and Foreign Exchange Intervention." American Economic Journal: Macroeconomics 11(2), pp. 127-170.

Engel, C., 2014. "Exchange Rates and Interest Parity." In: Handbook of International Economics, Vol. 4, edited by Gita Gopinath and Elhanan Helpman, pp. 453--522. Elsevier.

Fanelli, S., Straub, L., 2018. "A Theory of Foreign Exchange Interventions." 2018 Meeting Papers 1270, Society for Economic Dynamics.

Fernández-Villaverde, J., Rubio-Ramírez, J. F., Santos, M. S., 2006. "Convergence Properties of the Likelihood of Computed Dynamic Models." Econometrica 74(1), pp. 93-119.

Gabaix, X., Maggiori, M., 2015. "International Liquidity and Exchange Rate Dynamics." The Quarterly Journal of Economics 130(3), pp. 1369-1420.

Lindé, J., Trabandt, M., 2019. "Resolving the Missing Deflation Puzzle." CEPR Discussion Papers 13690.

Schmitt-Grohé, S., Uribe, M., 2003. "Closing Small Open Economy Models." Journal of International Economics 61(1), pp. 163-185.