UIP Holds Conditional on Monetary Policy Shocks

We estimate SVAR models for six advanced small open economies to evaluate the extent of deviations from uncovered interest parity following SOE and US monetary policy shocks. Since UIP implies that currency movements are driven by the expected path of the spread between the domestic and foreign short-term interest rates, our econometric strategy disciplines the dynamic response of the SOE-US policy rate differential to monetary disturbances. Specifically, our approach jointly identifies the systematic component of SOE and US monetary policy by combining block exogeneity and sign restrictions on policy parameters. We find that UIP broadly holds conditional on SOE and US monetary policy shocks irrespective of the observed exchange rate overshooting patterns.