Irving Fisher, Expectational Errors and the Uip Puzzle

33 Pages Posted: 17 Mar 2007

See all articles by Rachel A.J. Pownall

Rachel A.J. Pownall

Tilburg University - Department of Finance; Maastricht University - Department of Finance

Kees C. G. Koedijk

Tilburg University - Department of Finance

James R. Lothian

Gabelli School of Business, Fordahm University; National Bureau of Economic Research (NBER)

Ronald Mahieu

Tilburg University - Center for Economic Research, Econometrics and Finance Group; TiasNimbas Business School

Multiple version iconThere are 2 versions of this paper

Date Written: March 2007

Abstract

100 years ago this year, Irving Fisher adhered to 'price movements being imperfectly foreseen' resulting in short term deviations from UIP, which in the longer term are averaged away. In this paper, we first review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation relation. Like Fisher a century ago, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. The main contribution from our paper to the literature is by observing the UIP parity condition alongside PPP we are able to observe a common component in deviations in the parity conditions, which is highly correlated. To disentangle whether the common component is the risk premia or the size of errors made in forecasting exchange rates we introduce a third parity condition, the real interest equality. We find considerable commonality in deviations from UIP and PPP suggesting that these deviations are both driven by a common factor as the forecasting errors in exchange rates. Using a dynamic latent factor model we find that deviations from UIP are almost completely due to forecasting errors in exchange rates. Using recent developments in econometric techniques we are therefore able to show that Irving Fisher's conjecture to the source of what has become known as the UIP puzzle was in fact correct. We find that our results of expectational errors being the root of the UIP puzzle, rather than any large time variation in the size of the risk premia our extremely robust across countries and using alternative specifications.

Keywords: UIP, Irving Fisher, Expectations formation, Dynamic Latent Factor Model, Small-sample problems

JEL Classification: F31, B1

Suggested Citation

Pownall, Rachel Ann Jane and Koedijk, Kees G. and Lothian, James R. and Mahieu, Ronald J., Irving Fisher, Expectational Errors and the Uip Puzzle (March 2007). Available at SSRN: https://ssrn.com/abstract=971395 or http://dx.doi.org/10.2139/ssrn.971395

Rachel Ann Jane Pownall (Contact Author)

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

James R. Lothian

Gabelli School of Business, Fordahm University ( email )

113 West 60th Street
New York, NY 10023
United States
212-636-6147 (Phone)
212-765-5573 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ronald J. Mahieu

Tilburg University - Center for Economic Research, Econometrics and Finance Group ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2430 (Phone)
+31 13 466 3280 (Fax)

HOME PAGE: http://center.uvt.nl/staff/mahieu/

TiasNimbas Business School ( email )

Warandelaan 2
Tilburg, North-Brabant 5071HS
Netherlands

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