Uncovered Interest Parity, Forward Guidance and the Exchange Rate

• Authors: Jordi Galí.
• BSE Working Paper: 1021 | February 18
• Keywords: unconventional monetary policies , forward guidance puzzle , uncovered interest rate parity , open economy New Keynesian model
• JEL codes: E43, E58, F41
• unconventional monetary policies
• forward guidance puzzle
• uncovered interest rate parity
• open economy New Keynesian model

Under uncovered interest parity (UIP), the size of the e¤ect on the real exchange rate of an anticipated change in real interest rate di¤erentials is invariant to the horizon at which the change is expected. Empirical evidence using US, euro area and UK data points to a substantial deviation from that invariance prediction: expectations of interest rate di¤erentials in the near (distant) future are shown to have much larger (smaller) e¤ects on the real exchange rate than is implied by UIP. Some possible explanations are discussed.