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Irving Fisher and the UIP Puzzle: Meeting the Expectations a Century Later

  • Campbell-Pownall, R.A.J.
  • Koedijk, C.G.
  • Lothian, J.R.
  • Mahieu, R.J.

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 expectational errors in exchange rates, rather than attributable to the risk premium; a result consistent with those reported by Fisher a century ago.

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Paper provided by Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam in its series ERIM Report Series Research in Management with number ERS-2007-088-F&A.

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Date of creation: 07 Dec 2007
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Handle: RePEc:ems:eureri:10774
Contact details of provider: Postal: RSM Erasmus University & Erasmus School of Economics, PoBox 1738, 3000 DR Rotterdam
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  1. Evans, Martin D D & Lewis, Karen K, 1995. "Do Long-Term Swings in the Dollar Affect Estimates of the Risk Premia?," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 709-42.
  2. Nijman, T.E. & Palm, F.C. & Wolff, C.C.P., 1991. "Premia in forward foreign exchange as unobserved components," Discussion Paper 1991-12, Tilburg University, Center for Economic Research.
  3. Robert W. Dimand & John Geanakoplos, 2005. "Celebrating Irving Fisher," American Journal of Economics and Sociology, Wiley Blackwell, vol. 64(1), pages 3-18, 01.
  4. Robert W. Dimand, 1999. "Irving Fisher and the Fisher Relation: Setting the Record Straight," Canadian Journal of Economics, Canadian Economics Association, vol. 32(3), pages 744-750, May.
  5. Paul Hallwood, C. & MacDonald, Ronald & Marsh, Ian W., 2000. "Realignment expectations and the US dollar, 1890-1897: Was there a 'Peso problem'?," Journal of Monetary Economics, Elsevier, vol. 46(3), pages 605-620, December.
  6. Friedman, Milton & Schwartz, Anna J, 1991. "Alternative Approaches to Analyzing Economic Data," American Economic Review, American Economic Association, vol. 81(1), pages 39-49, March.
  7. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-80.
  8. Lucas, Robert E, Jr, 1980. "Two Illustrations of the Quantity Theory of Money," American Economic Review, American Economic Association, vol. 70(5), pages 1005-14, December.
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