Monetary Policy and Carry Trade

This paper discusses the relation between monetary policy and currency risk premium in the context of a model in which Central Banks diverge in terms of the preferences and act either under discretion or commitment. The... [ view full abstract ]

This paper discusses the relation between monetary policy and currency risk premium in the context of a model in which Central Banks diverge in terms of the preferences and act either under discretion or commitment. The model is able to reproduce sizable foreign currency risk premium under discretion when the Central Bank in the foreign country is less conservative than the monetary authority at home which leads to higher nominal interest rates and a counter-cyclical inflation in the foreign country. The model when calibrated to match key moments of real and nominal macroeconomic variables of Latin America countries can explain the excess returns of the currencies of the region