Department of Economics Working Papers,
Vienna University of Economics and Business, Department of Economics

Abstract: A large literature has related the failure of interest rate parity in the foreign exchange market to the existence of a time-varying risk premium. Nevertheless, most modern open economy DSGE models imply a (near) perfect interest rate parity condition. This paper presents a stylized two-country incomplete-markets model in which countries have strong precautionary motives because they face international liquidity constraints, the presence of which successfully generates a time-varying risk premium: the country that has accumulated debt after experiencing relative worse times has stronger precautionary motives and its asset carries a risk premium.

Keywords: Uncovered Interest Rate Parity, Incomplete Market, Precautionary Savings, Time-Varying Risk Premium

JEL-codes: F31; F41; G12; G15 March 2014

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