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

Journal article


Anderl, C. and Caporale, G. (2022). Testing for UIP-Type Relationships: Nonlinearities, Monetary Announcements and Interest Rate Expectations. Open Economies Review. https://doi.org/OPEN-D-21-00094R1
AuthorsAnderl, C. and Caporale, G.
Abstract

This paper tests for UIP-type relationships 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 Smooth Transition Cointegrated VAR (STCVAR) 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. While we cannot confirm the validity of UIP in its strictest theoretical sense, we find evidence for the existence of an equilibrium relationship between the exchange rate and the interest rate differential. Specifically, the nonlinear framework appears to be more appropriate to capture the adjustment towards the long-run equilibrium, since the estimated speed of adjustment is substantially faster and the short-run dynamic linkages more significant. 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, the equilibrium relationship between the exchange rate and the interest rate differential holds better in inflation targeting countries, where monetary authorities appear to achieve a higher degree of credibility.

KeywordsUIP; Exchange rate; Nonlinearities; Asymmetric adjustment; CVAR (Cointegrated VAR); STCVAR (Smooth Transition Cointegrated VAR); Interest rate expectations; Interest rate announcements
Year2022
JournalOpen Economies Review
PublisherSpringer
ISSN0923-7992
Digital Object Identifier (DOI)https://doi.org/OPEN-D-21-00094R1
Publication dates
Print14 Feb 2022
Publication process dates
Accepted06 Oct 2021
Deposited15 Feb 2022
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Open
Accepted author manuscript
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File Access Level
Controlled
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