Chapter 8: A UIP framework with regressive expectations
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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