Staff Report 371

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Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium

Fernando Alvarez - Consultant
Andrew Atkeson - Consultant
Patrick J. Kehoe - Consultant

Revised September 1, 2007

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.

Published In: Review of Economic Studies (Vol. 76, No. 3, July 2009, pp. 851-878)

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