Federal Reserve Bank of Minneapolis,

Under mild assumptions, the data indicate that time-varying risk is the primary force driving nom-inal interest rate differentials on currency-denominated bonds. This finding is an immediate impli-cation of the fact that exchange rates are roughly random walks. A general equilibrium monetary model with an endogenous source of risk variation–a variable degree of asset market segmentation– can produce key features of actual interest rates and exchange rates. In this model, the endogenous segmentation arises from a fixed cost for agents to exchange money for assets. As inflation varies, so does the benefit of asset market participation, and that changes the fraction of agents partici-pating. These effects lead the risk premium to vary systematically with the level of inflation. This model produces variation in the risk premium even though the fundamental shocks have constant conditional variances