Risk and Exchange Rates

Maurice Obstfeld, Kenneth Rogoff

NBER Working Paper No. 6694
Issued in August 1998
NBER Program(s):   IFM

This paper develops an explicitly stochastic new open economy macroeconomics' model, which can potentially be used to explore the qualitative and quantitative welfare differences between alternative exchange rate regimes. A crucial feature is that we do not simplify by assuming certainty equivalence for producer price setting behavior. Our framework also provides a sticky-price alternative to Lucas's (1982) exchage rate risk premium model. We show that the level risk premium' in the exchage rate is potentially quite large and may be an important missing fundamental in empirical exchange rate equations. As a byproduct analysis also suggests an intriguing possible explanation of the forward premium puzzle.

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Published: Helpman, Elhanan and Efraim Sadka (eds.) Contemporary Economic Policy: Essays in Honor of Assaf Razin. Cambridge University Press, 2003.

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