EXCHANGE-RATE DETERMINATION AND ASSET PRICES IN A STOCHASTIC SMALL OPEN-ECONOMY

This paper constructs a stochastic general equilibrium model of a small open economy consisting of risk-averse optimizing agents. The stochastic processes describing the rate of monetary growth, government expenditure, private production, and the foreign price level are taken to be exogenous, determining all asset risks and returns, and the equilibrium stochastic process describing the domestic inflation rate and the exchange rate. The model is used to examine the effects of the means and variances of policy shocks on the equilibrium and the determinants of the foreign exchange risk premium.