Irving Fisher, Expectational Errors and the Uip Puzzle
33 Pages Posted: 17 Mar 2007
Date Written: March 2007
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: Suggested Citation