rate movements is expected to be more pronounced in these countries due to high levels
of currency substitution.16 McCallum (1994) formally shows that monetary authorities’
policy reactions to contain exchange rates by using interest rate as a policy tool lead to
the joint determination of the expected depreciation and the interest differential. Ferreira
(2004) extends McCallum’s model by recognizing that central banks also take into account
recent inflation and output gap movements, and analyzes the presence of simultaneity bias
for emerging markets.17 His results suggest that monetary policy actions indeed induce a
simultaneity bias for the emerging market countries included in the analysis.
Monetary policy actions, particularly, monetary sterilization of capital inflows, may also
have implications for observed (and possibly persistent) deviations from the UIP condition.
In particular, ceteris paribus, capital inflows put a downward pressure on domestic interest
rate and hence on deviations from the UIP condition, when the central bank does not
completely sterilize these inflows. Therefore, deviations from the UIP condition might be
persistent due to monetary sterilization despite large and persistent capital inflows. Along
with this argument, Cavoli and Rajan (2006) analyze the persistent deviations from the UIP
condition for five East Asian countries for the period preceeding the crisis of 1997. They
report that large capital inflows to these countries had a negligible impact on deviations
from the UIP condition, and argue that given that capital is not perfectly mobile, monetary
sterilization policies of central banks can explain why deviations from the UIP condition
persist during the pre-crisis period.
A further supporting evidence for the effect of monetary policy actions on deviations
from the UIP condition is drawn by Poghosyan et al. (2007) who relate the foreign exchange
risk premium, ftk - ste+k , to the central bank’s interventions in the foreign exchange market
and ratio of deposits in domestic to foreign currencies. Poghosyan et al. report for Armenia
during 1997-2005 that the central bank’s such interventions indeed induce foreign exchange
risk premium and hence deviations from the UIP condition.
Although monetary authorities in emerging markets are expected to be more inclined to
react to exchange rate movements, the effect of such a “simultaneity” on the UIP condition
17