Working Paper: CEPR ID: DP1090
Authors: Robert P. Flood; Andrew K. Rose
Abstract: Regressions of ex-post changes in floating exchange rates on appropriate interest differentials typically imply that the high interest rate currency tends to appreciate - the `forward discount puzzle'. Using data from the European Monetary System we find that a large part of the forward discount puzzle vanishes for regimes of fixed exchange rates. That is, deviations from uncovered interest parity appear to vary in a way that is dependent upon the exchange rate regime. By using the many EMS realignments we are also able to quantify the `peso problem'.
Keywords: uncovered interest parity; exchange rate; floating; EMS; peso problem
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high interest rates (E43) | currency appreciation (F31) |
| floating exchange rates (F31) | negative slope coefficient for UIP (C29) |
| fixed exchange rates (F31) | slope coefficient approaches 0.6 (C29) |
| realignment exclusion (Y60) | significant change in slope coefficient (C20) |
| UIP deviations (L15) | less pronounced under fixed exchange rate regimes (F31) |