Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics

Article, Research, Preprint OPEN
Jonathan Eaton ; Stephen J. Turnovsky (1982)
  • Publisher: New Haven, CT: Yale University, Economic Growth Center
  • Journal: The Economic Journal, volume 93, issue 371 September, pages 555-75
  • Subject:
    • ddc: ddc:330

A number of macroeconomic models of open economies under flexible exchange rate assume a strong version of perfect capital mobility which implies that currency speculation commands no risk premium. If this assumption is dropped a number of important results no longer obtain. First, the exchange rate and interest rate cannot be in steady state unless both the government deficit and current account equal zero, not simply their sum, as would otherwise be the case. Second, even in steady state the domestic interest rate can deviate from the foreign interest rate by an amount which de ends upon relative domestic asset supplies. Finally, introducing risk aversion on the part of speculators can reduce the response on impact of the exchange rate to changes in domestic asset supplies. In this sense rational speculators, if they are less risk averse than other agents, can destabilize exchange markets.
  • References (3)

    Hansen, L. P. and R. J. Hodrick (1980) "Forward Exchange Rates as Optimal Predictors of Future Spot Rates," Journal of Political Economy, (October) 88, 829-853.

    Harris, R. G. and D. D. Purvis (1979) "Equilibrium Theories of the Forward Exchange Rate," Institute for Economic Research DisCU8SWfl Paper #354, Queen's University.

    Kouri, P. J. K. (1976) "The Determinants of the Forward Premium," Institute for International Economic Studies Paper No. 62, University of Stockholm, August.

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