Exchange Rate Economics

Exchange Rate Economics

The Uncovered Interest Parity Puzzle and Other Anomalies

Norman C. Miller

The Uncovered Interest Parity (UIP) puzzle has remained a moot point since it first circulated economic discourse in 1984 and, despite a number of attempts at a solution, the UIP puzzle and other anomalies in Exchange Rate Economics continue to perplex economic thought in international finance. This fundamental book fill gaps in scholarly literature by amalgamating key discourse to generate synthesis models which appear consistent with the UIP puzzle and related anomalies, uniquely bringing them together in one place. Through a comprehensive and current review of the literature, Norman C. Miller reveals new explanations for exchange rate anomalies and offers an alternative approach towards the UIP puzzle, stimulating and guiding future research.

Chapter 8: A UIP framework with regressive expectations

Norman C. Miller

Subjects: economics and finance, financial economics and regulation, history of economic thought, international economics


Synthesis Model II in Chapter 6 is consistent with the UIP puzzle and many other exchange rate anomalies and puzzling facts. It is capable of generating the UIP puzzle via: (a) a variable “risk premium” that is positively correlated with the interest rate differential (ID); (b) changes in what investors predict (now) for the value of the spot rate in the near future are negatively correlated with ID; (c) the fact that actual rates of decay in ID over some time interval might be less than anticipated; (d) persistent decreases in the anticipated rate of decay in IDs; and/or (e) fx market inefficiency that is severe enough that the “unexploited profit effect” dominates the “decaying ID effect”. This chapter assumes that ex ante UIP holds at the end of each period, as in Synthesis Model I, but it assumes that investors utilize regressive expectations, as defined in Chapter 7, equations (7.11a) and (7.11b). This can be viewed as one of many possible reasons for fx market inefficiency in the short run. However, we follow Dornbusch (1976) by showing that regressive expectations can satisfy rational expectations in the long run. As pointed out in Chapter 7, Marey (2004) uses regressive exchange rate expectations to generate a simulated time series for the spot rate that closely resembles the time series properties of real-world data. Also, in a much neglected paper, Frankel and Froot (1986) show that the existence of regressive expectations can generate endogenous persistent appreciations of a high interest rate currency.

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