Interest Parity at Short and Long Horizons

Abstract

The unbiasedness hypothesis -- the joint hypothesis of uncovered interest parity (UIP) and rational expectations -- has been almost universally rejected in studies of exchange rate movements. In contrast to previous studies, which have used short-horizon data, we test this hypothesis using interest rates on longer-maturity bonds for the G-7 countries. The results of these long-horizon regressions are much more positive — all of the coefficients on interest differentials are of the correct sign, and almost all are closer to the predicted value of unity than to zero. We first appeal to an econometric interpretation of the results, which focuses on the presence of simultaneity in a cointegration framework. We then use a macroeconomic model to provide an economic explanation for the differences between the short- and longhorizon results. Regressions run on model-generated data replicate the important regularities in the actual data, including the sharp differences between short- and long-horizon parameters. In the short run, the failure of the unbiasedness proposition results from the interaction of stochastic exchange market shocks with endogenous monetary policy reactions. In the long run, in contrast, exchange rate movements are driven by the "fundamentals", leading to a relationship between interest rates and exchange rates that is more consistent with UIP