Forward Bias, Uncovered Interest Parity and Related Puzzles

Abstract

Uncovered interest parity is widely used in open economy macroeconomics. But when exchange rates are flexible the evidence rejects UIP and implies forward bias. There are many suggested explanations for this 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 article shows how sterilized "leaning against the wind" and a combination of the inflationary and liquidity effects associated with 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.