Working Paper: NBER ID: w21042
Authors: Charles Engel
Abstract: The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms - indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands - one concerning short-run expected changes and the other concerning the level of the real exchange rate - have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. This paper documents the puzzle, and shows that existing models appear unable to account for both empirical findings. The features of a model that might reconcile the findings are discussed.
Keywords: No keywords provided
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high interest rate differential (E43) | expected excess return on foreign deposits (F31) |
| high interest rate differential (E43) | risk premium (G19) |
| risk premium (G19) | expected excess return on foreign deposits (F31) |
| expected future risk premiums (G17) | level of exchange rates (F31) |
| higher expected returns from foreign deposits (G15) | lower risk premiums (G22) |