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Bond premia, monetary policy and exchange rate dynamics

Anella Munro

I propose a model in which uncertainty about the value of ex-post payoffs drives a wedge - a short-term bond premium - between an observed short-term benchmark interest rate and the unobserved discount rate, that is used to allocate consumption over time. The model helps to explain disconnect between exchange rates and interest rate fundamentals; disconnect between measures of risk that price bonds and measures of risk that price currencies; and why exchange rates are "too smooth" relative to the volatile discount rates implied by equity premia. In the model with risk, the exchange rate response to monetary policy is observationally similar, whether monetary policy moves the discount rate or the bond market premium. Between policy changes, interest rate stabilisation (i) isolates the currency from variation in the discount rate; and (ii) shifts the expression of bond risk from bond yields to the currency premium. Those tradeoffs provide a risk-based interpretation of the monetary policy trilemma.