Working Paper: NBER ID: w0643
Authors: Pentti J. K. Kouri
Abstract: This paper analyzes the effects of real income and price level uncertainty on equilibrium interest rates. It is demonstrated that even if there are no outside nominal assets, the interest rate on nominal bonds contains a risk premium, or as the case may be, a risk discount. The sign, and the magnitude, of the deviation from the Fisher parity depends on the covariance between the purchasing power of money on the one hand and real income on the other. The second part of the paper extends the model into a model of two countries, two monies and two bonds denominated in these two monies. It is shown, in contrast with statements made in the literature, that the 'efficiency' of international financial markets does not imply equality of expected real interest rates on bonds denominated in different currencies, nor does it imply that the forward exchange rate should be an unbiased predictor of the future spot exchange rate. This is again true even when there are no outside nominal assets in the world economy.
Keywords: interest rates; risk premium; international finance
JEL Codes: E43; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| real income uncertainty (D89) | risk premium on nominal bonds (G12) |
| price level uncertainty (D89) | risk premium on nominal bonds (G12) |
| covariance between purchasing power and real income (F40) | risk premium on nominal bonds (G12) |
| changes in the mixture of bonds supplied by the government (H63) | risk premium on nominal bonds (G12) |
| real income uncertainty (D89) | equilibrium interest rates (E43) |
| price level uncertainty (D89) | equilibrium interest rates (E43) |
| efficiency of international financial markets (G15) | risk premium on nominal bonds (G12) |
| equal expected real interest rates across different currencies (E43) | risk premium on nominal bonds (G12) |
| forward exchange rates (F31) | risk premium on nominal bonds (G12) |