For Rich or for Poor: When does Uncovered Interest Parity Hold?” Working Paper

We present a model that simultaneously explains why uncovered interest parity holds for some pairs of countries and not for others. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep ’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The negative slope in the Fama regression arises when monetary instability is low and the precautionary savings motive dominates the intertemporal substitution motive. When monetary instability is high, the Fama slope is positive in line with uncovered interest parity. The model is simulated using the artificial economy methodology for 34 currencies against the US dollar. We conclude that, given the predominance of precautionary savings, the degree of monetary instability explains whether or not uncovered interest parity holds