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Systematic monetary policy and the forward premium puzzle

Demosthenes Tambakis () and Nikola Tarashev ()

No 396, BIS Working Papers from Bank for International Settlements

Abstract: Is systematic monetary policy a driver of the forward premium puzzle, i.e. the tendency of high interest-rate currencies to appreciate, thus strongly violating Uncovered Interest Parity (UIP)? We address this question by studying a battery of monetary policy rules in a small open economy that is subject to stationary but persistent domestic and foreign shocks. Each rule leads to model-implied UIP violations, which we derive analytically and then calibrate numerically. Our key finding is that only a forward-looking rule based on CPI inflation can account for frequently observed strong UIP violations.

Keywords: monetary policy rules; uncovered interest parity; exchange rate dynamics; inflation-targeting (search for similar items in EconPapers)
Pages: 42 pages
Date: 2012-12
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