[2022] Explain the economic basis for Covered Interest Parity and Uncovered Interest Parity. Discuss
the role of Uncovered Interest Parity in macroeconomic adjustment following a positive, permanent
and unexpected demand shock in an open economy with an inflation targeting central bank (assume a
vertical ERU curve in your answer). To what extent is this predicted response likely to be observed in
practice?
CIP and UIP
• Para: Covered Interest Parity is about the relationship between interest rates on risk-free assets
(bonds) denominated in different currencies.
o
oIn the presence of forward currency markets, the covered return on bonds denominated
in different currencies should be equalized.
o Illustrate: If it<it*, borrow home currency at lower rate to buy foreign currency bond and
earn higher rate. This sell pressure on home currency causes depreciation, so Et is high,
Ft+1< Et. When you try to sell back returns after bond matures into home currency, you
exchange at an appreciated home currency rate, so that you have no net gain despite
enjoying higher nominal bond yield.
o Students should refer to the presence of an arbitrage opportunity were CIP to fail.
o A very interesting answer could mention that in the presence of limits to arbitrage (say
financial frictions) even CIP might fail.
• Para: Uncovered Interest Parity is about the relationship between interest rates and expected
future exchange rates.
o
o
o 𝑟 − 𝑟∗ = 𝑞𝑡+1𝑒 −𝑞𝑡 = 𝐸(∆𝑞)
o Depending on how expected future exchange rates are measured, UIP typically fails
empirically.
o Students should focus on the difference between future covered and expected
exchange rates. They could also note that while CIP refers to riskless arbitrage, even if
UIP were to hold, arbitrage would only be eliminated in expectation.
Para: Positive permanent AD shock overview
• For the effects of a positive demand shock please refer to the diagram at the end of the part A
solutions headed ‘Open Economy Essay’. This shows the effects of a positive, permanent and
unexpected demand shock.
• The economy moves from A to B in the period of the shock. The policy-maker targets C in the
good market in period t+1 and this is achieved at the equivalent points C on the RX locus in the
IS diagram and on the QQ locus in the UIP diagram. In subsequent periods there is adjustment
from C towards A (A’ in the UIP diagram) along the MR, RX and QQ lines.
, Para: UIP's role
• UIP plays a key role throughout this adjustment. In the first instance the permanent aggregate
demand shock appreciates the equilibrium real exchange rate from A to A’ as shown in (y,q)
space in the AD-ERU plot.
• UIP states that the current real exchange rate is the equilibrium real exchange rate adjusted for
the sum of current and expected future real interest rate differentials between the home
economy and the rest of the world.
o
• Agents therefore appreciate the current real exchange rate immediately and this accounts for
the UIP line shifting from UIP to UIP’, and also explains why the economy ultimately returns to a
point on IS (even though it’s a permanent shock IS shifts only temporarily since in equilibrium
the real appreciation crowds out net exports).
• There is a further effect from UIP in this adjustment. In response to a positive demand shock,
forex markets foresee that domestic interest rates will exceed the world level in the future, as
well as in the present period (at points such as C and in subsequent periods during convergence
to A). The result is that UIP forces a large appreciation of the nominal and real exchange rates
immediately. The UIP’ curve shifts by an additional amount to UIP’’ on account of the additional
appreciation forced through by monetary policy.
• The real appreciation causes a leftward shift of IS to IS’’ due to net exports falling. As time goes
forwards the UIP curve and IS curve shifts unwind and the adjustment is along the QQ and RX
loci that are flatter than the stand alone UIP and IS relationships.
Para: q/ UIP plays 2 roles: assists short run policy (shifts IS curve), Long run stabiliser.
Para: Whether the above pattern of adjustment is likely to be observed in practice depends on:
• Whether UIP holds (and it may fail due to arbitrage frictions, risk aversion on the part of
investors and so on) and
• Whether net exports decline with exchange rate appreciation (may fail in the short-run if the
Marshall-Lerner condition does not hold).
the role of Uncovered Interest Parity in macroeconomic adjustment following a positive, permanent
and unexpected demand shock in an open economy with an inflation targeting central bank (assume a
vertical ERU curve in your answer). To what extent is this predicted response likely to be observed in
practice?
CIP and UIP
• Para: Covered Interest Parity is about the relationship between interest rates on risk-free assets
(bonds) denominated in different currencies.
o
oIn the presence of forward currency markets, the covered return on bonds denominated
in different currencies should be equalized.
o Illustrate: If it<it*, borrow home currency at lower rate to buy foreign currency bond and
earn higher rate. This sell pressure on home currency causes depreciation, so Et is high,
Ft+1< Et. When you try to sell back returns after bond matures into home currency, you
exchange at an appreciated home currency rate, so that you have no net gain despite
enjoying higher nominal bond yield.
o Students should refer to the presence of an arbitrage opportunity were CIP to fail.
o A very interesting answer could mention that in the presence of limits to arbitrage (say
financial frictions) even CIP might fail.
• Para: Uncovered Interest Parity is about the relationship between interest rates and expected
future exchange rates.
o
o
o 𝑟 − 𝑟∗ = 𝑞𝑡+1𝑒 −𝑞𝑡 = 𝐸(∆𝑞)
o Depending on how expected future exchange rates are measured, UIP typically fails
empirically.
o Students should focus on the difference between future covered and expected
exchange rates. They could also note that while CIP refers to riskless arbitrage, even if
UIP were to hold, arbitrage would only be eliminated in expectation.
Para: Positive permanent AD shock overview
• For the effects of a positive demand shock please refer to the diagram at the end of the part A
solutions headed ‘Open Economy Essay’. This shows the effects of a positive, permanent and
unexpected demand shock.
• The economy moves from A to B in the period of the shock. The policy-maker targets C in the
good market in period t+1 and this is achieved at the equivalent points C on the RX locus in the
IS diagram and on the QQ locus in the UIP diagram. In subsequent periods there is adjustment
from C towards A (A’ in the UIP diagram) along the MR, RX and QQ lines.
, Para: UIP's role
• UIP plays a key role throughout this adjustment. In the first instance the permanent aggregate
demand shock appreciates the equilibrium real exchange rate from A to A’ as shown in (y,q)
space in the AD-ERU plot.
• UIP states that the current real exchange rate is the equilibrium real exchange rate adjusted for
the sum of current and expected future real interest rate differentials between the home
economy and the rest of the world.
o
• Agents therefore appreciate the current real exchange rate immediately and this accounts for
the UIP line shifting from UIP to UIP’, and also explains why the economy ultimately returns to a
point on IS (even though it’s a permanent shock IS shifts only temporarily since in equilibrium
the real appreciation crowds out net exports).
• There is a further effect from UIP in this adjustment. In response to a positive demand shock,
forex markets foresee that domestic interest rates will exceed the world level in the future, as
well as in the present period (at points such as C and in subsequent periods during convergence
to A). The result is that UIP forces a large appreciation of the nominal and real exchange rates
immediately. The UIP’ curve shifts by an additional amount to UIP’’ on account of the additional
appreciation forced through by monetary policy.
• The real appreciation causes a leftward shift of IS to IS’’ due to net exports falling. As time goes
forwards the UIP curve and IS curve shifts unwind and the adjustment is along the QQ and RX
loci that are flatter than the stand alone UIP and IS relationships.
Para: q/ UIP plays 2 roles: assists short run policy (shifts IS curve), Long run stabiliser.
Para: Whether the above pattern of adjustment is likely to be observed in practice depends on:
• Whether UIP holds (and it may fail due to arbitrage frictions, risk aversion on the part of
investors and so on) and
• Whether net exports decline with exchange rate appreciation (may fail in the short-run if the
Marshall-Lerner condition does not hold).
