Foreign exchange rate risk in a small open economy

Bianca De Paoli () and Jens Sondergaard

No 365, Bank of England working papers from Bank of England

Abstract: Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.

Pages: 31 pages
Date: 2009-03-20
New Economics Papers: this item is included in nep-cba, nep-dge and nep-ifn
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Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0365

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