Imperfect financial integration, uncovered interest parity and central bank foreign exchange reserves

This paper explores the implications of costly international portfolio adjustment by private agents, on the effects of central bank interventions on interest rates, and on short and long-horizon uncovered interest parity (UIP). Using an incomplete-markets two-country monetary model with bonds in positive net supply, we show that with portfolio adjustment costs, surprise central bank interventions can have a substantial negative effect on foreign interest rates. In addition, central bank interventions and monetary policy shocks cause deviations from UIP, or a “forward premium anomaly”. As the time horizon increases, the model-implied regression coefficients become more consistent with the long-run evidence in favor of UIP, as in the data for the major currencies. A crucial element of the analysis is the interaction between the central bank balance sheet, the agents budget constraints, and market clearing conditions in both bond markets. ∗I would like to thank Fernando Zapatero, Chris Jones and Selale Tuzel for helpful comments and suggestions, and Ondra Kamenik for help with dynare++ v.1.3.6. †PhD candidate at the department of Finance and Business Economics, Marshall School of Business, University of Southern California, Los Angeles, CA 90089-1427, USA (e-mail: [email protected]) 1 USC FBE FINANCE SEMINAR presented by Jesus Sierra FRIDAY, Oct. 31, 2008 10:30 am 12:00 pm, Room: JKP-202