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Endogenous Risk Premium, Inflation Targets and Flexible Exchange Rate: Dynamic Implications of the Bresser-Nakano Hypothesis for a Small Open Economy

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  • José Luís Oreiro

Abstract

The objective of this article is to analyze the implications of Bresser-Nakano hypothesis, that risk-premium is positive related to domestic rate of interest, over time paths of nominal interest rate and nominal exchange rate in a small open economy whose regime of economic policy is characterized by flexible exchange rate, inflation targeting and short run capital mobility. In the theoretical framework developed in the article, we are able to shown that, in the case of a strong positive feedback of nominal interest rate over risk-premium, (i) there are multiple time paths of nominal interest rate and nominal exchange rate; (ii) all such paths are compatible with some degree of price stability and (iii) some of these paths, however, are related to an increase in current account deficit and/or a continuous increase in fiscal deficit. The logical conclusion of these results is that the achievement of current account and fiscal equilibrium can only be obtained by a change in the regime of economic policy. JEL Classification: E4; E6; F32.

Suggested Citation

  • José Luís Oreiro, 2002. "Endogenous Risk Premium, Inflation Targets and Flexible Exchange Rate: Dynamic Implications of the Bresser-Nakano Hypothesis for a Small Open Economy," Brazilian Journal of Political Economy, Center of Political Economy, vol. 22(3), pages 491-507.
    • Handle: RePEc:ekm:repojs:v:22:y:2002:i:3:p:491-507:id:947
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    Keywords

    Risk premium; interest rate trap; Bresser-Nakano hypothesis;
    All these keywords.

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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