Modeling exchange rate dynamics in Peru: A cointegration approach using the UIP and PPP

This paper investigates whether the Purchasing Power Parity (PPP) and the Uncovered Interest Rate Parity (UIP) hold for the Peruvian economy. We analyze Peruvian, international and trade-weighted foreign data for the period 1997 - 2011 using Johansen's cointegration approach. The results of our analysis suggest the existence of two stationary relations obtained after imposing overidentifying restrictions, which represent a combination of the UIP with the PPP and an equation for an augmented risk premium. In terms of monetary policy, our findings provide evidence that the aim of the Central Bank's intervention in the currency market is to smooth short-run volatility of the exchange rate, but does not have a long-run effect. After a successful identification of the stationary relations, we develop a permanent-transitory analysis following Gonzalo & Ng (2001) in order to analyze the impact of structural shocks to the error correction model variables and some relations of interest.