Breaking the UIP: A Model-Equivalence Result

Abstract

Breaking the uncovered interest rate parity (UIP) is essential to accounting for exchange rate dynamics, and is required for modeling sterilized foreign exchange interventions. Gabaix and Maggiori (2015) account for many exchange rate puzzles by introducing financial intermediaries that absorb savings imbalances for a premium, thereby deviating from the UIP. Fanelli and Straub (2021) analyze foreign exchange interventions. In their model, regulatory exposure limits and participation cost in the international financial markets drive a wedge in the UIP. This paper demonstrates that, to a first-order approximation, introducing a reduced-form portfolio adjustment cost is isomorphic to these modeling strategies.