Uncertain Exchange Rate Policies and Interest Rate Determination

Uncertain Exchange Rate Policies and Interest Rate Determination We analyse how an uncertain exchange rate policy affects interest rate differences between countries participating in a managed exchange rate system. It is shown that the interest rate of asmall and open economy always has a positive risk premium relative to the interest rate of a big and open economy. The paper explores the complex deviation from the uncovered interest rate parity condition implied by positive risk premia. Specifically, it turns out that the interest rate is increasing in the potential size of a devaluation, but a higher probability of a depreciation does not necessarily increase the interest rate, since expectations and variances may be affected in different direction