Note: I’m working through Tyler’s 2005 Macro final. You’d be out of your mind to take a formal economics class in this blogosphere.
2. What is the difference between covered and uncovered interest parity? Which are assumed by the traditional Dornbusch model of exchange rate overshooting? None, just one, or both? How do the observed failures of the expectations theory of the term structure affect the Dornbusch model?
Covered parity means you have a forward contract guaranteeing you your money back. Uncovered parity means you’re exposed to exchange rate fluctuations not offset by interest rate changes.
I had to look up Dornbusch, but I remember his ideas from the CFA exams. The point here is that the economy adjusts to shocks in a lumpy way as information is processed by affected sectors and knock-on effects are realized.
Anyway, the point is that interest rates change based on local equilibria which themselves might be based on asset prices that adjust only slowly to shocks. Think about how long it takes house prices to adjust to changes in interest rates. The full expression of the shock might take a longer and more meandering path than we expect.
Not sure what failures in the term structure Tyler’s talking about here but a wonky term structure would mean that different rates within asset classes will react in different ways. This just seems to make rates even less predictable. I wouldn’t want to be in charge of that model.
And when the changes, when they come, come fast. Consider how this affects the information transmission of price systems. Tyler himself recently quoted James Hamilton that the market will change its view quickly (on Italian debt, for instance) when perception switches to ruin.