A Reconsideration of Uncovered Interest Rate Parity under Switching Policy Regimes

It is shown that when monetary authorities manage the interest rate through anti-inflationary policy rules which allow for occasional discrete shifts, then a Markov switching regimes representation is appropriate for the exchange rate and the interest rate differential series. In this setting, tests of the uncovered interest rate parity (UIP) hypothesis, based on the cross-equation restrictions on the parameters of a Markov switching regimes representation for the underlying variables, show that the interest parity relationship is not rejected 144 D.G. Kirikos for the currencies of Germany and the U.K. vis-à-vis the U.S. dollar over the period 1973-1997. These results suggest that previously reported failures of UIP may be the outcome of rational forecast errors induced by central bank interventions.