Expectations and the UIP Puzzles when Foresight is Limited

Abstract

This paper investigates exchange rate dynamics and its forecast errors by incorporating bounded rationality in a small open-economy New Keynesian model. Decision-makers possess limited foresight, capable of planning only up to a finite distance into the future. This yields dynamic overshooting of forecast errors in the real exchange rate across different time horizons. It also distinguishes between short- and long-term expectation formations, where the Law of Iterated Expectations breaks. This framework hence provides a micro-foundation for understanding time- and forecast-horizon variability in uncovered interest parity (UIP) puzzles. Our model predictions on these UIP violations align both qualitatively and quantitatively with empirical estimates.

Keywords: Finite planning horizon, UIP violations, value function learning, small open economy, exchange rate

JEL Classification: E43, E70, F31, F41