No 115. UIP for short investments in long-term bonds

by Annika Alexius

Abstract

The empirical failure of uncovered interest parity (UIP) is one of the best-established facts of international economics. The exchange rates of countries with high nominal interest rates tend to appreciate rather than depreciate as expected from UIP. However, virtually every published test of UIP studies short interest rates. In this paper, UIP is found to hold for carefully calculated returns to investments in long-term bonds and the US dollar - Deutsche mark exchange rate. For the corresponding short interest rates, the standard finding of a significantly negative relationship is confirmed. The results are explained in terms of a small macroeconomic model where the short interest rate is used as a monetary policy instrument to stabilise output and inflation.