The Risk Premium, Interest Rate Determination, and Monetary Independence Under a Fixed, but Adjustable, Exchange Rate

• Published date: 01 October 2016
• Date: 01 October 2016
• DOI: http://doi.org/10.1002/ijfe.1548
• Author: Kit Pasula

THE RISK PREMIUM, INTEREST RATE DETERMINATION, AND

MONETARY INDEPENDENCE UNDER A FIXED, BUT ADJUSTABLE,

EXCHANGE RATE

KIT PASULA*

Department of Economics, University of British Columbia, Okanagan, Kelowna, British Columbia, Canada

ABSTRACT

This paper examines interest rate determination and monetary independence in a small economy with a fixed exchange rate. The

risk premium is determined endogenously in the stochastic, general-equilibrium model. The sign of the risk premium and the

magnitude of the interest rate depend on the specification of the policy rule for the future exchange rate. Increases in domestic

credit can decrease, increase or have no effect on the interest rate. The offset coefficient can differ from 1 (the ‘trilemma’may

not hold), but numerical calculations indicate that the offset is close to 1. Under certain conditions, empirical analyses over-

estimate monetary independence. Copyright © 2016 John Wiley & Sons, Ltd.

Received 20 May 2015; Revised 17 December 2015; Accepted 18 January 2016

JEL CODE: E52; E58; F3; F41

KEY WORDS: fixed exchange rate; monetary independence; interest rate parity; risk premium; offset coefficient

1. INTRODUCTION

The trilemma asserts that a country cannot simultaneously enjoy a fixed exchange rate, unrestricted international

asset trade and monetary independence (Obstfeld, Shambaugh, and Taylor (2005)). But the trilemma, even in a

small economy, does not hold unambiguously. The extent of monetary independence depends on the degree to

which exogenous policy actions cause changes in expected net wealth and thereby induce changes in the interest

rate, consumption and the demand for money. The central bank may have some control of the nominal money

supply, even though the exchange rate is fixed and international asset trade is unrestricted. While this conclusion

is not always acknowledged, it was highlighted in the seminal literature on the analysis of fixed exchange rates

in stochastic, choice-theoretic, general-equilibrium models (Stockman, 1983).

1

This modelling approach is now one of the standard frameworks with which questions in international macro-

economics are addressed. With respect to monetary independence under a fixed exchange rate, an additional benefit

of this approach is that it allows one to rigorously model the determination of the risk premium (on foreign relative

to domestic bonds). This matter is important because an interest rate parity condition implies that the central bank

in a small economy can affect the domestic interest rate only if it is able to influence the risk premium (assuming

zero, or constant, marginal portfolio transactions costs). In addition, these general-equilibrium models allow one to

address causality questions that are especially difficult in fixed exchange rate regimes: Do the monetary policy

variables cause changes in the risk premium and the interest rate or do other factors cause changes in the risk

premium, which then induce changes in the interest rate and the monetary policy variables?

*Correspondence to: Kit Pasula, Department of Economics (Arts Building), University of British Columbia, Okanagan, 1147 Research Road,

Kelowna, British Columbia V1V 1V7, Canada.

E-mail: kit.pasula@ubc.ca

Copyright © 2016 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 313–331 (2016)

Published online 17 February 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1548

To conduct a detailed analysis of monetary independence, one cannot assume that the exchange rate is fixed per-

manently because the risk premium is then zero. One needs to allow for the possibility that the future exchange rate

can change (and to allow it to co-vary with future consumption). But this is exactly how fixed exchange rate regimes

tend to work in practice. Fixed exchangerate regimes are not regimes wherethe exchange rate is immutably fixed,but

rather are regimes of fixed,but adjustable, exchange rates (Obstfeld and Rogoff, 1995; Klein and Shambaugh, 2008).

This paper examines interest rate determination and monetary independence in an environment of a fixed, but

adjustable, nominal exchange rate (for a small economy). The basic model is a standard, stochastic, general-

equilibrium model with exogenous output, a Ricardian representative agent, real money in the utility function

and unrestricted international asset trade in a foreign nominal bond.

2

Because the allowance for uncertainty com-

plicates the analysis, a number of simplifying assumptions are adopted. In particular, the agent’s utility function is

quadratic, the policy rule for the future exchange rate is linear and there are only two time periods (on using two-

period models when there is uncertainty, see Barsky (1989) and Kimball and Weil (2009)). On the other hand, the

model is complicated by the introduction of two features that generate non-neutralities: one based on the central

bank’s holdings of foreign currency reserves (Stockman, 1983; Persson, 1984) and another based on portfolio

transactions costs (Schmitt-Grohe and Uribe, 2003; Flood and Jeanne, 2005).

The purpose of the paper is not simply the analysis of interest rate determination and monetary independence

under a fixed exchange rate but the analysis of these issues when the risk premium is determined endogenously

in a general-equilibrium framework.

3

What factors cause fluctuations in the risk premium and the domestic interest

rate in this environment? Does the structure of the fixed exchange rate regime influence the magnitude of the risk

premium? Can the central bank, through changes in domestic credit, affect the risk premium and the interest rate?

To what extent are changes in domestic credit offset by endogenous reserve flows? Is the offset coefficient equal to

1 or does the central bank enjoy a degree of monetary independence? These questions are fundamental issues in

the operation of a fixed exchange rate regime.

The theoretical analysis gene rates a number of interesting results . The sign of the risk premium and the mag-

nitude of the nominal interest r ate depend on the specification of the poli cy rule for the future exchange rate.

Exogenous increases in domest ic credit can decrease, increase or have n o effect on the nominal interest rate.

The offset coefficient can be gre ater than, equal to or less than 1, but numeric al calculations indicate that it is

close to 1 (the trilemma may no t hold, but monetary independen ce is negligible). Finally, und er certain condi-

tions, empirical analyses over estimate both central bank influence on the inte rest rate and the extent of monetary

independence.

The research in this paper is in line with recent research in international macroeconomics emphasizing the

risk premium. Duarte and Stockman (2005) and Alvarez, Atkeson, and Kehoe (2007, 2009) outline general-

equilibrium models of the risk premium and the exchange rate and argue forcefully that fluctuations in the risk

premium must be given significantly more emphasis in open economy models.

4

Thereisalargeliteratureonthe

determination of the risk premium in choice-theoretic, general-equilibrium models, but this research assumes

that the exchange rate is flexible (the surveys by Engel (1996, 2014) and Lewis (2011) discuss this literature).

When researchers examine fixed exchange rates, the conventional assumption is that the exchange rate is fixed

permanently. Very few papers have examined the interaction between monetary policy and an endogenously

determined risk premium in an environment of a fixed, but adjustable, exchange rate.

5

Important exceptions

include, for example, Mendoza and Uribe (2000, 2001), but the focus of these papers was not on the extent

of monetary independence.

The recent literature has also highlighted portfolio transactions costs as the basis for a mechanism through

which the central bank may affect the interest rate under a fixed exchange rate, even though international asset

trade is unrestricted. Flood and Jeanne (2005), for example, add portfolio transactions costs to a perfect foresight,

speculative attack model. In their model, exogenous decreases in domestic credit induce changes in the marginal

portfolio adjustment cost and thereby cause an increase in the domestic interest rate. This paper abstracts from

this mechanism, by assuming that marginal portfolio transactions costs are constant, and focuses on the risk

premium.

The next two sections outline the model and discuss the risk premium and the policy rule. The following two

sections analyse interest rate determination and monetary independence and discuss issues related to other factors

that affect the risk premium. A final section concludes.

KIT PASULA314

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 21: 313–331 (2016)

DOI: 10.1002/ijfe