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

Rachel Pownall (), Kees Koedijk, James Lothian and Ronald Mahieu

No ERS-2007-088-F&A, ERIM Report Series Research in Management from 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

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

Keywords: Irving Fisher; PPP; UIP; exchange rates; inflation; interest rates (search for similar items in EconPapers)
JEL-codes: E42 G3 M (search for similar items in EconPapers)
Date: 2007-12-07
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