Money and Currency Market Implications of the Long Run Risk Models

Abstract

Using postwar US and UK data, we study the implied interest rates and exchange rates in a simple Long Run Risk (LRR) model with two countries. When a closed economy is considered, emprical estimates show that, as in standard CCAPM models, the movements of the risk free rate implied by a baseline LRR model are entirely determined by the variations of the expected consumption growth. Nevertheless, differently from the standard CCAPM, the long run component of consumption growth is a key element to capture the counter-cyclical variations of the money market rates. Turning to an open economy setting, we find evidence that a baseline LRR model accounts for foreign exchange market movements.