Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here, we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation - a variable degree of asset market segmentation.
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Acknowledgements. The authors thank George Marios Angeletos, Martin Boileau, Charles Engel, Michael Devereux, Pierre-Olivier Gourinchas, Juan Pablo Nicolini, Pedro Teles, Chris Telmer, Linda Tesar, Jaume Ventura, and Ivan Werning for helpful comments. The authors also thank the National Science Foundation for financial assistance and Kathy Rolfe and Joan Gieseke for excellent editorial assistance. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.