Breaking the UIP: A Model-Equivalence Result
Breaking the uncovered interest rate parity (UIP) condition is essential to accounting for the empirical behavior of exchange rates and is a prerequisite for theoretical analysis of sterilized foreign exchange interventions. Gabaix and Maggiori (2015) account for some of the long-standing empirical exchange rate puzzles by introducing financial intermediaries that are willing to absorb international saving imbalances for a premium, thereby deviating from the UIP. In another important contribution, Fanelli and Straub (2019) lay down the principles for foreign exchange interventions. In their model, regulatory exposure limits and participation cost in the international financial markets drive a wedge in the UIP. This paper demonstrates that, to a first-order approximation, a simple reduced-form portfolio adjustment cost friction, as in Schmitt-Grohé and Uribe (2003), generates identical deviations from the UIP as the micro-founded models mentioned above. Therefore, to the extent that one is only concerned with first-order dynamics and second moments, there is no gain from adopting the rich microstructure of either models – the simple ad-hoc adjustment cost is just as good.