Foreign exchange rate risk in a small open economy
AbstractResolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.
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Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 365.
Length: 31 pages
Date of creation: 20 Mar 2009
Date of revision:
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-03-28 (All new papers)
- NEP-CBA-2009-03-28 (Central Banking)
- NEP-DGE-2009-03-28 (Dynamic General Equilibrium)
- NEP-IFN-2009-03-28 (International Finance)
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