Uncertainty and the uncovered interest parity condition: How are they related?

Abstract

A well-established literature in open macroeconomics documents the failure of the uncovered interest parity (UIP) condition. While a host of factors have been examined as possible reasons for this failure, the role of uncertainty is not fully understood. This paper examines how economic policy uncertainty affects the UIP condition in a panel of fourteen economies over 2003:1–2021:12. There is evidence of an uncertainty threshold on the UIP condition under risk neutrality. This threshold splits the sample endogenously into two different regimes—a “low-uncertainty regime" and a “high-uncertainty regime." While the UIP condition holds in the former regime, it fails in the latter. This finding is robust to the inclusion of risk-premium proxies to allow for risk aversion, ex-post exchange rates, different deposit maturities, and estimation methods.