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 explain the related puzzles discussed below.  This paper shows how the liquidity effects of open market operations and sterilized “leaning against the wind” can explain the failure of UIP and forward bias even when expectations are rational.  They also appear to be able to explain the related puzzles better than any of the alternatives.