An Empirical Investigation of UIP and PPP in Inflation Targeting Countries

This thesis consists of three empirical chapters, which study the role of central bank credibility in influencing the exchange rate parities in inflation targeting countries. Central bank credibility is considered to be of upmost importance to the success of the inflation targeting regime. The increasing popularity of inflation targeting as a monetary policy framework requires an evaluation of its wider implications on the economy compared to alternative monetary regimes. This thesis provides insight into the relation between central bank credibility and the exchange rate parities in a comparative study of inflation targeting countries and countries that operate alternative monetary regimes. The first empirical chapter investigates the extent to which deviations from the Taylor rule influence the exchange rate parities. The use of a nonlinear framework provides evidence for the strong persistence of deviations from the parities when Taylor rule deviations are large. The findings of the comparative study show that central bank credibility is more important in inflation targeting countries than in nontargeting countries. The second empirical chapter considers the role of interest rate expectations as an often overlooked measure of central bank credibility when investigating the UIP relation. Using a nonlinear framework, the findings are able to confirm the validity of UIP when the public expects the central bank to adopt a tight monetary stance with closer adherence to the inflation target. The final empirical chapter analyses the role of macroeconomic shocks including inflation expectations shocks in a nonlinear model of the real exchange rate. It is shown that the adjustment to PPP is partially influenced by central bank credibility shocks, in particular those arising from survey expectations.