A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

Abstract

A new monetary theory is set out to resolve the "uncovered interest parity (UIP)" puzzle. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premia. We show that the UIP can fail to hold under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit-based transactions are relatively bigger. Our liquidity-based theory can help understanding many empirical observations that risk-based explanations find difficult to reconcile with.