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Exchange Rates, Macroeconomic Fundamentals and Risk AversionJose OlmoCentro Universitario de la Defensa de Zaragoza; City University London - Department of Economics Ricardo Laborda Herreroaffiliation not provided to SSRN March 10, 2011 Abstract: This paper shows that under absence of arbitrage opportunities the exchange rate reacts to restore equilibrium in international bond markets. The key factors determining its value are the difference between realized and implicit interest rate differentials, the underlying risk premium in bond markets and changes in market expectations on the long run exchange rate. The application of this model to the macroeconomy reveals the importance of the risk premium for setting monetary policy. We find that a relative increase/decrease in the risk premium between foreign and domestic debt markets increases/decreases the influence of foreign monetary policy for shifting real output.
Number of Pages in PDF File: 24 Keywords: Foreign Exchange Markets, International Bond Markets, Uncovered Interest Parity Condition JEL Classification: C22, F31 working papers seriesDate posted: January 12, 2011 ; Last revised: March 12, 2011Suggested CitationContact Information
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