EXCHANGE RATES AND INTEREST RATES IN MEXICO: A MARKOV REGIMESWITCHING APPROACH

Ricardo Tovar-Silos
Lamar University
ABSTRACT
A Markov regime-switching model is applied to the time series of the Mexican Peso-
U.S. Dollar exchange rate and to the Mexican interest rate. The existence of two states is
statistically significant in both cases. The exchange rate is characterized by extended periods
of low variance and slight appreciations followed by short-lived high variance and
depreciation states. The interest rate is characterized by a long run decrease in interest rates
that can be decomposed in two periods: one with high rates and increased volatility before
2004 and another with low rates and decreased volatility after that year. It was found that the
states of these time series are in sync 44.9% of the time due mainly to the persistence of the
states rather than due to the correlation between the high volatility-depreciation state in
exchange rates and the high volatility state in interest rates.