Covered Interest Parity, Uncovered Interest Parity and Exchange Rate Dynamics
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.
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Volume (Year): 93 (1983)
Issue (Month): 371 (September)
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- Willem H. Buiter & Marcus Miller, 1991.
"Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation,"
in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 239-277
National Bureau of Economic Research, Inc.
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- Willem H. Buiter & Marcus H. Miller, 1981. "Real Exchange Rate Overshooting and the Output Cost of Bringing Down Inflation," NBER Working Papers 0749, National Bureau of Economic Research, Inc.
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- James Tobin & Willem H. Buiter, 1974. "Long Run Effects of Fiscal and Monetary Policy on Aggregate Demand," Cowles Foundation Discussion Papers 384, Cowles Foundation for Research in Economics, Yale University.
- Driskill, Robert, 1980. "Exchange Rate Dynamics, Portfolio Balance, and Relative Prices," American Economic Review, American Economic Association, vol. 70(4), pages 776-783, September.
- Turnovsky, Stephen J., 1981. "The asset market approach to exchange rate determination: Some short-run, stability, and steady-state properties," Journal of Macroeconomics, Elsevier, vol. 3(1), pages 1-32.
- Turnovsky,Stephen J., 1977. "Macroeconomic Analysis and Stabilization Policy," Cambridge Books, Cambridge University Press, number 9780521291873, December.
- Richard Harris & Douglas D. Purvis, 1979. "Equilibrium Theories of the Forward Exchange Rate," Working Papers 354, Queen's University, Department of Economics.
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