School of Economics

2004 Discussion Papers

School of Economics Discussion Paper 04/13
October 2004

Leaning Against the Parity
Alex Luiz Ferreira

School of Economics
University of Kent at Canterbury

Abstract

The paper presents evidence that the simultaneous relationship between uncovered interest rate parity (UIP) and a monetary policy function can explain the empirical failure of the former. Using the model proposed by McCallum (1994), we carry out tests for a sample of developed and emerging markets from 1995M5 to 2004M3. The results lend strong support to the view that monetary policy affects the equilibrium nominal interest rate differential between emerging economies and the US. Slow adjustment in interest rates and reaction against price changes seem to be the prominent features of the reaction function. Shocks have an asymmetric impact on the volatility of the differentials which is also significant to explain monetary policy. Finally, the dynamic properties of uncovered interest rate parity ex post deviations, also interpreted as risk premium, influence the equilibrium nominal interest rate differentials.

JEL Classification: E43, E52, E58, F31

Keywords: Uncovered Interest Rate Parity, Monetary Policy, Reaction Function, Interest Rates

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