Introduction

The exchange rate is a key transmission channel for monetary policy in conventional macro models that assume flexible exchange rates. Particularly since the work of Dornbusch (1976), the link between exchange rates and monetary policy in such models has been increasingly embodied in the uncovered interest parity (UIP) condition. Under UIP, the expected change in the exchange rate equals the interest rate differential between domestic and foreign assets. This establishes a simple and transparent link between monetary policy actions – as reflected in interest rate movements – and the exchange rate.

Although attractive from a theoretical viewpoint, there are two issues that need to be addressed in implementing the conventional framework. The first is the awkward fact that the existence of UIP has been resoundingly rejected in empirical studies, as documented in a vast literature. At face value, the empirical failure of UIP calls into question the specification of the exchange rate transmission channel in conventional models. Is there a way of explaining this empirical failure that can rescue the conventional means of specification?

The second issue involves interpreting the role of the exchange rate as a monetary transmission channel, even if UIP holds. UIP specifies only the relationship between the expected future change in the exchange rate and the current interest differential between domestic and foreign assets. Holding the expected future value of the exchange rate constant, a rise in the domestic interest rate, under UIP, would lead to an appreciation of the domestic currency.