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Irving Fisher, Expectational Errors, and the UIP Puzzle

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Author Info
Campbell, Rachel
Koedijk, Kees
Lothian, James R
Mahieu, Ronald J

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Abstract

We review Irving Fisher’s seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are connected to individual episodes in which errors surrounding exchange rate expectations are persistent, but eventually transitory. We find considerable commonality in deviations from UIP and PPP, suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model, we find that deviations from UIP are almost entirely due to forecasting errors in exchange rates, a result consistent with those reported by Fisher a century ago.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6294.

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Date of creation: May 2007
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Handle: RePEc:cpr:ceprdp:6294

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Keywords: Expectations formation Irving Fisher small-sample problems UIP

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F31 - International Economics - - International Finance - - - Foreign Exchange

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  4. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 471-488, August. [Downloadable!] (restricted)
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