Breaking the UIP: A Model-Equivalence Result

Yossi Yakhin ()

MPRA Paper from University Library of Munich, Germany

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.

Keywords: UIP; Financial Frictions; Open Economy Macroeconomics (search for similar items in EconPapers)
JEL-codes: E58 F31 F41 (search for similar items in EconPapers)
Date: 2019-11-17, Revised 2020-03-24
New Economics Papers: this item is included in nep-dge, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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https://mpra.ub.uni-muenchen.de/107411/8/MPRA_paper_107411.pdf revised version (application/pdf)

Related works:
Journal Article: Breaking the UIP: A Model‐Equivalence Result (2022)
Working Paper: Breaking the UIP: A Model-Equivalence Result (2020)
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