UIP, Expectations and the Kiwi

This paper looks at reduced form descriptions of changes in the USD/NZD exchange rate, with emphasis on the interest rate-exchange rate relationship. In the estimated reduced form equations, high domestic short term interest rates relative to foreign interest rates are associated with continued upward pressure on the New Zealand dollar. This effect is most pronounced for the 6-month forward interest differential, and is reinforced by some "inertia" but moderated by deviations from equilibrium as "over or under-valuation" erodes expected returns. Changes in commodity export prices are estimated to have short term effects. Some aspects of the estimated equations are consistent with forward-looking rational expectations, a standard feature of open economy models. Other aspects of the estimated equations suggest random walk exchange rate expectations consistent with Meese and Rogoff (1983). The cross correlation between interest differentials and the exchange rate may be difficult to reconcile with rational expectations. The forecasting performance of a reduced form equation is also assessed.