Modeling Interest Rate Parity: A System Dynamics Approach

The theory of uncovered interest rate parity has enjoyed very little empirical support. Despite the fact that global financial markets trade seven days a week, twenty-four hours a day and communication takes place almost instantaneously, there are strong indications that differences in expected rates of return across countries can be non-zero and large for extended periods of time. However, these deviations display a pattern within which there is an important clue regarding their cause. Changes in the differences between expected rates of return across countries largely correspond to changes in the differences between national interest rates. In other words, when agents expect the rate of return (taking into account both interest rates and forecast exchange rate movements) to be higher in one country than another, that country also tends to have the higher interest rates. This means, as will be demonstrated below, that deviations from uncovered interest rate parity cannot be explained (as has been argued elsewhere) by relying on the assumption that agents perceive some assets to be riskier than others. A model of international financial flows that incorporates John Maynard Keynes ’ concept of forecast confidence, however, has no difficulty explaining this commonly observed phenomenon. The purpose of this paper is to show the superiority of Keynes ’ approach by comparing thre