Department of Economics

Uncovered interest parity is widely used in open economy macroeconomics.  But the evidence rejects UIP and implies forward bias.  There are many suggested explanations for the failure of UIP and forward bias, but none are widely accepted, at least partially because none appear to explain the related puzzles discussed below.  This paper shows how sterilized “leaning against the wind” and a combination of inflationary and liquidity effects of open market operations can explain forward bias and the failure of UIP even when expectations are rational.  They also appear to be able to explain the related puzzles.