Deviations from uncovered interest parity in a DSGE model

Empirical studies have shown that the uncovered interest parity condition does not hold. Deviations from uncovered interest parity imply that the forward rate is a biased predictor of the future exchange rate, a phenomenon known as the forward premium puzzle: High-interest currencies tends to appreciate over time relative to low-interest currencies.

Chin and Meredith (2004) show that macroeconomic models can reproduce the deviations from uncovered interest parity observed in the data by including what they call “exchange market shocks”. For example, if such shocks can cause the domestic currency to depreciate, output and inflation will rise and the central bank will respond by raising interest rates. This “leaning against the wind” response by the central bank causes the exchange rate and the cross-country interest rate differential to move in opposite directions, causing deviations from uncovered interest parity. Their approach raises some interesting questions: What is the variance and persistence of those exchange market shocks? If they are an important factor driving exchange rates, what percentage of exchange rate movements is actually explained by changes in macroeconomic fundamentals? How do variations in monetary policy practices across countries affect the deviations from uncovered interest parity for different currencies?

The purpose of my project is to answer those questions. I plan to build a dynamic stochastic general equilibrium (DSGE) model that can be used to estimate the properties of exchange market shocks for different countries. That model can be used to calculate the percentage of exchange rate movements caused by each type of exogenous shock at different horizons and how the magnitude and persistence of uncovered interest parity deviations depend on the central bank’s response to economic conditions. Overall, the paper aims to better understand exchange rate movements using a model that is consistent with the deviations from uncovered interest parity observed in the data.