Explaining US-UK Interest Rate Differentials: A Reassessment of the Uncovered Interest Rate Parity in a Bayesian Framework

In this paper, we test the uncovered interest rate parity (UIRP), allowing for transitory deviations from it. These deviations may arise from variations in risk premia, errors in expectations and linearization errors, and are modelled as a zero-mean noise around the restrictions implied by the UIRP on a vector autoregression (VAR) in the interest rate differential and the spot exchange rate. Importantly, this approach includes the traditional one as a special case, which is derived by simply setting the noise to zero. When the noise is set to zero the UIRP is rejected, but if we allow for some degree of noise the UIRP is strongly supported by the data. Thus the UIRP relation does not hold exactly, but on average, with a stationary risk premium as opposed to a constant one. This result implies that analysing the effects of policy experiments under the null of the UIRP may be both safe and useful. Copyright 2006 Blackwell Publishing Ltd.