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Staff Report 371
Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium
Fernando Alvarez
Andrew Atkeson - Consultant .
Patrick J. Kehoe - Monetary Advisor
Revised September 2008
Abstract
Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation.
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