On the Foreign-Exchange Risk Premium in Sticky-Price General Equilibrium Models

This paper investigates the behavior of the foreign exchange risk premium in two recent two-country intertemporal-optimizing general equilibrium models with sticky nominal prices: Obstfeld-Rogoff (1998) and Devereux-Engel (1998). The foreign exchange risk premium in any general equilibrium model arises from the correlation of the exchange rate with consumption. In flexible price models, that requires correlation of monetary and output supply shocks. In sticky-price models, the correlation arises endogenously because monetary shocks cause output and consumption to change. The size of the risk premium depends on how prices are set (in producers' currencies versus consumers' currencies), and on the form of the money demand function. In some cases, the risk premium generated by the model is quite large.