Exchange Rates, Macroeconomic Fundamentals and Risk Aversion

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