DP6294 Irving Fisher, Expectational Errors, and the UIP Puzzle

Author(s): Rachel Campbell, Kees Koedijk, James R Lothian, Ronald J Mahieu
Publication Date: May 2007
Keyword(s): Expectations formation, Irving Fisher, small-sample problems, UIP
JEL(s): B01, F31
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6294

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.