Irving Fisher, the UIP Puzzle and the 'Peso Problem'

In this paper, we first review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation relation. We go on to re-examine the performance of UIP since the advent of floating exchange rates in the 1970s. Like Fisher a century ago, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. We see evidence of this behavior both in the changed coefficients estimates from rolling regressions. We also find considerable commonality in deviations from UIP and PPP suggesting that these deviations are both driven by a common factor as the forecasting errors in exchange rates. Using a dynamic latent factor model we find that deviations from UIP are almost completely due to forecasting errors in exchange rates. Once the variation in the size of the forecasting errors is taken into account we find empirical support of a unitary value for the implied beta in the Fama regression. Using a number of countries we find unanimous support that deviations from UIP are driven by errors made in forecasting exchange rates, a result which we attribute to Irving Fisher who first mentioned this a century to date