Uncovered Interest Parity with Fundamentals: A Brazilian Exchange Rate Forecast Model

Abstract

One of the most challenging elements of the inflation-targeting framework is the exchange rate forecast. Wadhwani (1999) proposed a UIP, where real variables like the unemployment differential, the current account differential, and the excess return of financial assets affect the expected exchange rate. The objectives of this paper are first to include, as in Wadhwani (1999), some real variables to anchor exchange rate expectations. In our case, the long-run value of the exchange rate is determined by balanced external accounts. Second, we use this approach to simulate the behavior of key macroeconomic variables in an inflation-targeting structural model for Brazil. Finally, we compare the results with those of a random walk specification. The impulse responses under the UIP-with-fundamentals model seemed to be more realistic than those obtained by using other specifications for exchange rate forecasts.