Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics

45 Pages Posted: 7 Apr 2004 Last revised: 11 Sep 2010

See all articles by Jonathan Eaton

Jonathan Eaton

Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

Stephen J. Turnovsky

University of Washington - Institute for Economic Research; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: September 1982

Abstract

A number of macroeconomic models of open economies under flexible exchange rate assume a strong version of perfect capital mobility which implies that currency speculation commands no risk premium. If this assumption is dropped a number of important results no longer obtain. First, the exchange rate and interest rate cannot be in steady state unless both the government deficit and current account equal zero, not simply their sum, as would otherwise be the case. Second, even in steady state the domestic interest rate can deviate from the foreign interest rate by an amount which de ends upon relative domestic asset supplies. Finally, introducing risk aversion on the part of speculators can reduce the response on impact of the exchange rate to changes in domestic asset supplies. In this sense rational speculators, if they are less risk averse than other agents, can destabilize exchange markets.

Suggested Citation

Eaton, Jonathan and Turnovsky, Stephen J., Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics (September 1982). NBER Working Paper No. w0984. Available at SSRN: https://ssrn.com/abstract=302562

Jonathan Eaton (Contact Author)

Leonard N. Stern School of Business - Department of Economics ( email )

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HOME PAGE: http://www.econ.nyu.edu/user/eatonj/

National Bureau of Economic Research (NBER)

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Stephen J. Turnovsky

University of Washington - Institute for Economic Research ( email )

Seattle, WA 98195
United States
206-685-8028 (Phone)
206-543-5955 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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