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Expectations and the UIP puzzles when foresight is limited

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  • Na, Seunghoon
  • Xie, Yinxi

Abstract

This paper studies exchange rate dynamics and excess currency returns by incorporating bounded rationality into a small open-economy New Keynesian model. Decision-makers have limited foresight, planning only up to a finite horizon and approximating continuation values with coarse value functions learned from past experiences. This behavior generates an initial underreaction, followed by an overreaction in beliefs, leading to dynamic overshooting of exchange rate forecast errors. Moreover, the coexistence of forward- and backward-looking components in expectation formation breaks the forecast-horizon invariance implied from rational expectations. Our model thus provides a micro-foundation for understanding time- and forecast-horizon variability in uncovered interest parity (UIP) puzzles, and its predictions align closely with empirical estimates.

Suggested Citation

  • Na, Seunghoon & Xie, Yinxi, 2025. "Expectations and the UIP puzzles when foresight is limited," Journal of International Economics, Elsevier, vol. 158(C).
    • Handle: RePEc:eee:inecon:v:158:y:2025:i:c:s0022199625001400
    DOI: 10.1016/j.jinteco.2025.104183
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    References listed on IDEAS

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    Keywords

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    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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