DP567 Exchange Rate Risk and Imperfect Capital Mobility in an Optimizing Macromodel
A stochastic two-period model of a small open economy with optimizing consumption and portfolio choice is constructed. Exchange rate risk means domestic-currency bonds are imperfect substitutes for foreign-currency bonds. Expectations are rational, i.e. subjective probability distributions equal the true distributions resulting from the exogenous sources of uncertainty, which in this model are the foreign inflation rate and either the future money supply or government spending. With the former, no real risk premium exists, but increased monetary variance reduces current output, which nominal wage rigidity makes responsive to aggregate demand. With the latter source of uncertainty a premium exists, but neither the risk premium nor output is affected by an increased variance of government spending.
