Working Paper: NBER ID: w21159
Authors: Menzie D. Chinn; Yi Zhang
Abstract: Relying upon a standard New Keynesian DSGE, we propose an explanation for two empirical findings in the international finance literature. First, the unbiasedness hypothesis – the proposition that expost exchange rate depreciation matches interest differentials – is rejected much more strongly at short horizons than at long. Second, even at long horizons, the unbiasedness hypothesis tends to be rejected when one of the currencies has experienced a long period of low interest rates, such as in Japan and Switzerland. Using a calibrated New Keynesian dynamic stochastic general equilibrium model, we show how a monetary policy rule can induce the negative (positive) correlation between depreciation and interest differentials at short (long) horizons. The tendency to reject unbiasedness for Japan and Switzerland even at long horizons we attribute to the interaction of the monetary reaction function and the zero lower bound.
Keywords: uncovered interest parity; unbiasedness hypothesis; rational expectations; exchange rates; zero lower bound; New Keynesian model
JEL Codes: E12; F21; F31; F41; F47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Interest Rate Differentials (E43) | Exchange Rate Depreciation (F31) |
| Unbiasedness Hypothesis Rejection (Short Horizons) (G14) | Interest Rate Differentials (E43) |
| Interaction of Monetary Policy Reaction Functions and ZLB (E52) | Breakdown in Expected Relationship (C29) |
| Long Horizon Interest Differentials (E43) | Positive Coefficients (C29) |
| Short Horizon Interest Differentials (E43) | Negative Coefficients (C29) |
| Low-Interest Rates (Japanese Yen and Swiss Franc) (E43) | Rejection of Unbiasedness Hypothesis (C12) |