Solving the Forward Discount Bias Puzzle in a Small Open Developing Economy

Abstract

This article tests the validity of a Forward Discount Bias Puzzle, in a small open developing economy (SODE)—Sri Lanka—by employing first an unstructured vector autoregression (VAR) model and then a structured VAR model. The author argues that empirical examinations concerning SODEs cannot merely replicate methodology followed in testing developed economies, and identifies the need to disentangle capital flows from interest rate changes by including both capital flow and monetary policy variables. The article finds no evidence of a Forward Discount Bias Puzzle in Sri Lanka, and that perfect capital mobility is a too strong assumption. Hence, it proves that empirically more appropriate approach is to assume some capital mobility and incorporate capital flow data to accommodate for this change, in the analysis of UIRP.