Working Paper: NBER ID: w0984
Authors: Jonathan Eaton; Stephen J. Turnovsky
Abstract: 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.
Keywords: Exchange Rates; Interest Parity; Capital Mobility; Risk Aversion
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| domestic asset supplies (F21) | domestic interest rate (E43) |
| foreign interest rates (E43) | domestic interest rate (E43) |
| domestic interest rate (E43) | exchange rate (F31) |
| risk aversion (D81) | response of exchange rate to domestic asset supplies (F31) |
| government deficit and current account balance (F32) | steady-state conditions for exchange rate and interest rate (E43) |
| risk aversion (D81) | sensitivity of exchange rate adjustments to asset supply changes (F31) |