Testing for UIP: Nonlinearities, Monetary Announcements and Interest Rate Expectations

Christina Anderl and Guglielmo Maria Caporale

No 9027, CESifo Working Paper Series from CESifo

Abstract: This paper re-examines the UIP relation by estimating first a benchmark linear Cointegrated VAR including the nominal exchange rate and the interest rate differential as well as central bank announcements, and then a Cointegrated Smooth Transition VAR (CVSTAR) model incorporating nonlinearities and also taking into account the role of interest rate expectations. The analysis is conducted for five inflation targeting countries (the UK, Canada, Australia, New Zealand and Sweden) and three non-targeters (the US, the Euro-Area and Switzerland) using daily data from January 2000 to December 2020. We find that the nonlinear framework is more appropriate to capture the adjustment towards the UIP equilibrium, since the estimated speed of adjustment is substantially faster and the short-run dynamic linkages are stronger. Further, interest rate expectations play an important role: a fast adjustment only occurs when the market expects the interest rate to increase in the near future, namely central banks are perceived as more credible when sticking to their goal of keeping inflation at a low and stable rate. Also, central bank announcements have a more sizeable short-run effect in the nonlinear model. Finally, UIP holds better in inflation targeting countries, where monetary authorities appear to achieve a higher degree of credibility.

Keywords: UIP; exchange rate; nonlinearities; asymmetric adjustment; CVAR (Cointegrated VAR); CVSTAR (Cointegrated Smooth Transition VAR); interest rate expectations; interest rate announcements (search for similar items in EconPapers)
JEL-codes: C32 F31 G15 (search for similar items in EconPapers)
Date: 2021
New Economics Papers: this item is included in nep-cba, nep-eec, nep-ets, nep-mac, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:ces:ceswps:_9027

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