The uncovered interest parity puzzle concerns the empirical regularity that high interest rate countries tend to have high expected returns on short term deposits. A separate puzzle is that high real interest rate countries tend to have currencies that are stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two findings have apparently contradictory implications for the relationship of the foreign-exchange risk premium and interest-rate differentials. We document these puzzles, and show that existing models appear unable to account for both. A model that might reconcile the findings is discussed. (JEL E43, F31, G15)

This paper examines optimal monetary policy in an open-economy two-country world with sticky prices under pricing to market. We show that currency misalignments are inefficient and lower world welfare. We find that optimal policy must target consumer price inflation, the output gap, and the currency misalignment. The paper derives the loss function of a cooperative monetary policymaker and the optimal targeting rules. The model is a modified version of Clarida, Galí, and Gertler (JME, 2002). The key change is that we allow pricing to market or local-currency pricing and consider the policy implications of currency misalignments. JEL: E52, F31, F41

This study measures the proportion of U.S. real exchange rate movements that can be accounted for by movements in the relative prices of nontraded goods. The decomposition is done at all possible horizons that the data allow‐from one month up to 30 years. The accounting is performed with five different measures of non‐traded‐goods prices and real exchange rates, for exchange rates of the United States relative to a number of other high‐income countries in each case. The outcome is surprising: relative prices of movement of U.S. real exchange rate with Japan. The possibility of mismeasurement of traded‐goods prices is explored.

This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. The traditional approach maintains that exchange-rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price response to exchange-rate changes—specifically, that there appears to be a large degree of local-currency pricing (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries.

The real value of the US dollar has fluctuated widely during the global financial crisis and its aftermath. Beginning in early 2008 through early 2009, the dollar strengthened against most currencies but weakened considerably in the intervening months. We propose a decomposi tion of the forces driving the real exchange rate into a long run real interest rate component and a residual risk premium component. If real interest rates in the United States rise rela tive to its partners, the value of the dollar should strengthen. Likewise, if the level risk premium on foreign interest-bearing assets rises, the dol lar should also strengthen. We find that little of the recent movements in the dollar are directly attributable to the real interest component, sug gesting that most of the movements are due to the residual risk premium component. There is a large and diverse literature that affords a role to real interest differentials and to risk premiums in determining the real value of a currency. Our approach is almost purely definitional. The only assumptions we rely on are those of stationarity?of the real exchange rate and the US-foreign real interest differen tial. Specifically, let qt denote the log of the real exchange rate, defined as the foreign con sumer price level (converted into dollar terms

Accounting for Exchange-Rate Variability in Present-Value Models When the Discount Factor Is Near 1 by Charles Engel and Kenneth D. West. Published in volume 94, issue 2, pages 119-125 of American Economic Review, May 2004

We use CPI data for U.S. and Canadian cities for 14 categories of consumer prices to examine the nature of the deviations from the law of one price. The distance between cities explains a significant amount of the variation in the prices of similar goods in different cities. But the variation of the price is much higher for two cities located in different countries than for two equidistant cities in the same country. We explore some of the reasons for this finding. Sticky nominal prices appear to be one explanation but probably do not explain most of the border effect.

The value of the dollar appears to move in one direction for long periods of time. We develop a new statistical model of exchange rate dynamics as a sequence of stochastic, segmented time trends. We reject the null hypothesis that exchange rates follow a random walk in favor of our model of long swings. Our model also generates better forecasts than a random walk. The specification is a natural framework for assessing the importance of the "peso problem" for the dollar. We nonetheless reject uncovered interest parity.

We show analytically that in a rational expectations present‐value model, an asset price manifests near–random walk behavior if fundamentals are I(1) and the factor for discounting future fundamentals is near one. We argue that this result helps explain the well‐known puzzle that fundamental variables such as relative money supplies, outputs, inflation, and interest rates provide little help in predicting changes in floating exchange rates. As well, we show that the data do exhibit a related link suggested by standard models—that the exchange rate helps predict these fundamentals. The implication is that exchange rates and fundamentals are linked in a way that is broadly consistent with asset‐pricing models of the exchange rate.

Abstract We find strong empirical evidence that the liquidity yield on government bonds in combination with standard economic fundamentals can well account for nominal exchange rate movements. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all the G10 countries, and we stress that the US dollar is not special in this relationship. We show how these relationships arise out of a canonical two-country New Keynesian model with liquidity returns. Additionally, we find a role for sovereign default risk and currency swap market frictions.