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Testing for UIP: Nonlinearities, Monetary Announcements and Interest Rate Expectations

Author

Listed:
  • Christina Anderl
  • Guglielmo Maria Caporale
Abstract
This paper re-examines the UIP relation by estimating first a benchmark linear Cointegrated VAR including the nominal exchange rate and the interest rate differential as well as central bank announcements, and then a Cointegrated Smooth Transition VAR (CVSTAR) model incorporating nonlinearities and also taking into account the role of interest rate expectations. The analysis is conducted for five inflation targeting countries (the UK, Canada, Australia, New Zealand and Sweden) and three non-targeters (the US, the Euro-Area and Switzerland) using daily data from January 2000 to December 2020. We find that the nonlinear framework is more appropriate to capture the adjustment towards the UIP equilibrium, since the estimated speed of adjustment is substantially faster and the short-run dynamic linkages are stronger. Further, interest rate expectations play an important role: a fast adjustment only occurs when the market expects the interest rate to increase in the near future, namely central banks are perceived as more credible when sticking to their goal of keeping inflation at a low and stable rate. Also, central bank announcements have a more sizeable short-run effect in the nonlinear model. Finally, UIP holds better in inflation targeting countries, where monetary authorities appear to achieve a higher degree of credibility.

Suggested Citation

  • Christina Anderl & Guglielmo Maria Caporale, 2021. "Testing for UIP: Nonlinearities, Monetary Announcements and Interest Rate Expectations," CESifo Working Paper Series 9027, CESifo.
    • Handle: RePEc:ces:ceswps:_9027
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    File URL: https://www.cesifo.org/DocDL/cesifo1_wp9027.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    UIP; exchange rate; nonlinearities; asymmetric adjustment; CVAR (Cointegrated VAR); CVSTAR (Cointegrated Smooth Transition VAR); interest rate expectations; interest rate announcements;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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