Intertemporal Substitution, Precautionary Saving, and the Currency Risk Premia
33 Pages Posted: 10 May 2018 Last revised: 19 Oct 2020
Date Written: October 18, 2020
There are two seemingly contradictory empirical regularities in international finance: the high interest rate currency tends to have higher currency risk premia in short horizons but lower currency risk premia in long horizons. Engel (2016) shows that existing models cannot accommodate these two puzzles simultaneously and terms them a paradox. In this paper, we provide a rational resolution to Engel's paradox. Our deviation from existing models is the following two assumptions on consumption processes: (i) the expected future consumption variance have more than one decay modes and (ii) the mean consumption growth depends on the slowest decay mode. Market friction, recursive utility and bounded rationality are not assumed. Calibration exercises confirm key implications of our model.
Keywords: Interest rates, exchange rates, currency risk premia, intertemporal substitution, precautionary saving
JEL Classification: E43, F31, G15
Suggested Citation: Suggested Citation