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Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics

  • Jonathan Eaton
  • Stephen J. Turnovsky

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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0984.

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Date of creation: Sep 1982
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Publication status: published as Eaton, Jonathan and Stephen J. Turnovsky. "Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics." Economic Journal, Vol. 93, No. 3. Cambridge University Press, (Sept. 1983), pp. 555-575. Journal of Economic Literature Vol. 22, No.1, (March 1984).
Handle: RePEc:nbr:nberwo:0984
Note: ITI IFM
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  1. 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.
  2. 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.
  3. Dornbusch, Rudiger & Fischer, Stanley, 1980. "Exchange Rates and the Current Account," American Economic Review, American Economic Association, vol. 70(5), pages 960-71, December.
  4. Driskill, Robert, 1980. "Exchange Rate Dynamics, Portfolio Balance, and Relative Prices," American Economic Review, American Economic Association, vol. 70(4), pages 776-83, September.
  5. Richard Harris & Douglas D. Purvis, 1979. "Equilibrium Theories of the Forward Exchange Rate," Working Papers 354, Queen's University, Department of Economics.
  6. Buiter, Willem H. & Miller, Marcus, 1982. "Real exchange rate overshooting and the output cost of bringing down inflation," European Economic Review, Elsevier, vol. 18(2), pages 85-123.
  7. Wilson, Charles A, 1979. "Anticipated Shocks and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 87(3), pages 639-47, June.
  8. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-38, April.
  9. Aliber, Robert Z, 1973. "The Interest Rate Parity Theorem: A Reinterpretation," Journal of Political Economy, University of Chicago Press, vol. 81(6), pages 1451-59, Nov.-Dec..
  10. repec:cup:cbooks:9780521291873 is not listed on IDEAS
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