For Rich or for Poor: When does Uncovered Interest Parity Hold?

Maurice Roche and Michael Moore

No 15, Working Papers from Toronto Metropolitan University, Department of Economics

Abstract: We present a model that simultaneously explains why uncovered interest parity holds for some pairs of countries and not for others. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The negative slope in the Fama regression arises when monetary instability is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary instability is high, the Fama slope is positive in line with uncovered interest parity. The model is simulated using the artificial economy methodology for 34 currencies against the US dollar. We conclude that, given the predominance of precautionary savings, the degree of monetary instability explains whether or not uncovered interest parity holds.

Keywords: Monetary instability; Uncovered interest parity; Forward biasedness puzzle; Carry trade; Habit persistence (search for similar items in EconPapers)
JEL-codes: F31 F41 G12 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2010-05
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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