Inflation Adjustment, Endogenous Risk Premium and Exchange Rate: A Theoretical Analysis

Abstract

This article develops a full employment monetary framework that deals with the interaction between exchange rate and inflation rate dynamics, emphasising the existence of risk premium. The economy consists of internal and foreign bonds. These are close substitutes since there exists a risk premium that depends on inflation rate, budget deficit and net exports. According to the monetary policy rule, both inflation rate and exchange rate negatively influence money supply. Overtime, changes in inflation rate are proportional to the excess supply in the money market. The dynamic adjustment of exchange rate arises due to discrepancy between home interest rate and world rate of interest and risk premium. Based on this framework, we investigate the implications of increase in exports, technological innovation and policy mix for the interaction between exchange rate and inflation rate. JEL Codes: E31, E63, F32, F41