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.
|Date of creation:||Sep 1982|
|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).|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
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- Driskill, Robert, 1980. "Exchange Rate Dynamics, Portfolio Balance, and Relative Prices," American Economic Review, American Economic Association, vol. 70(4), pages 776-783, September.
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NBER Working Papers
0749, National Bureau of Economic Research, Inc.
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- Aliber, Robert Z, 1973. "The Interest Rate Parity Theorem: A Reinterpretation," Journal of Political Economy, University of Chicago Press, vol. 81(6), pages 1451-1459, Nov.-Dec..
- Richard Harris & Douglas D. Purvis, 1979. "Equilibrium Theories of the Forward Exchange Rate," Working Papers 354, Queen's University, Department of Economics.
- Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-338, April.
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