Carry On Wayward Yen

A recent Econ 317 homework problem (ch. 10, problem #5 from Greg Mankiw's intermediate macro book) illustrated the concept of uncovered interest parity (UIP). One of the major puzzles in open-economy macroeconomics is the fact that this condition fails to hold in the data. On his blog, Mankiw muses on whether there is money to be made in the "carry trade," which relies on the violation of UIP:

It is rare that I leave an economics conference with information that will change my personal financial decisionmaking. But I was close yesterday. A fascinating discussion of a paper on the carry trade made me wonder whether I should put a little money there.

The carry trade refers to the act of borrowing from countries with low interest rates, lending to countries with high interest rates, and profiting from the interest rate differential. It is based on the hope that exchange rates will not move too much against you to wipe out the profit. In other words, it is gambling that a condition known as uncovered interest parity will not hold. In the past, this strategy has been a money-maker. That is, uncovered interest parity is a plausible hypothesis that empirical studies usually reject.

We don't have the UIP violations quite figured out yet, but surely a brilliant economist like Mankiw would not entertain the thought that there any large bills on the sidewalk to be picked up. Besides, he already knows a much less risky way to get rich. (and yes, the title of this post is a Kansas reference)