Working papers, Department of Economics, WU (Wirtschaftsuniversität Wien)
An Incomplete Markets Explanation to the UIP Puzzle
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; (follow links to similar papers)
JEL-Codes: F31,; F41,; G12,; G15; (follow links to similar papers)
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