Effects of monetary disturbances on exchange rates with risk averse speculation

This paper develops a macroeconomic model in which domestic and foreign bonds are perfect substitutes on a covered basis, but in which speculators are assumed to be risk averse. We analyze the effects of various transitory and permanent disturbances on the economy and show how the existence of the risk premium, known to exist under such conditions, has important implications for macroeconomic behavior. Most of our attention is devoted to how the economy responds to temporary and permanent changes in the money and bond supplies and in the central bank's forward market position. The effects of disturbances in the foreign price level and interest rate are also briefly discussed.