Comment on: Exchange rates, expected returns and risk: what can we learn from Asia-Pacific currencies?

Uncovered interest rate parity (UIP) is probably the most popular component of small open economy models used for monetary policy analysis. Based on an arbitrage assumption, it predicts that nominal exchange rates respond to movements in nominal interest rates, both domestic and foreign. The intuition is simple: higher domestic (foreign) interest rates generate capital inflows (outflows) that demand domestic (foreign) currency, causing a nominal appreciation (depreciation).