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The present work deals with a frequently detected failure of the Uncovered Interest rate Parity (UIP) - the absence of bivariate co-integration between domestic and foreign interest rates. The authors explain non-stationarity of the interest differential via central bank reactions to exchange rate variations. Thereby, the exchange rate in levels introduces an additional stochastic trend into the system. Trivariate co-integration between the interest rates and the exchange rate accounts for the missing stationarity property of the interest differential. They apply the concept to the case of Turkey and Europe, where they can validate the theoretical considerations by multivariate time series techniques.
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