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

18 Pages Posted: 20 Jul 2000 Last revised: 26 Oct 2022

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Date Written: April 1999

Abstract

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.

Suggested Citation

Engel, Charles M., On the Foreign-Exchange Risk Premium in Sticky-Price General Equilibrium Models (April 1999). NBER Working Paper No. w7067, Available at SSRN: https://ssrn.com/abstract=227423

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