A Liquidity‐Based Resolution of the Uncovered Interest Parity Puzzle

Abstract

A new monetary theory is set out to resolve the "Uncovered Interest Parity Puzzle (UIP Puzzle)". It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premium due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage condition ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory in fact has interesting implications on many empirical observations that risk based explanations find difficult to reconcile with.

Liquidity and the International Allocation of Economic Activity

“…The model in this article is related to the two‐country models of Geromichalos and Simonovska (2014), Geromichalos and Jung (2018), and Lee and Jung (2020), who introduce new monetarist frameworks to explain international finance phenomena such as the positive correlation between consumption and asset home bias, the link between the foreign‐exchange market and international trade, and the uncovered interest parity puzzle. This article is also related to models that try to explain global imbalances—which feature capital flows from emerging countries to rich countries (the so‐called Lucas paradox)—as a result of cross‐country differences in financial development.…”