ABSTRACT

Overshooting was also a feature of the PBA model derived in Chapter 8. Thus the imperfect substitutability of non-money assets, tantam ount to imperfect capital mobility, also gave a story of exchange rate overshooting. The choice between the SPMA (and the - flexible price monetary approach - FLMA) and the PBA was seen to boil down to the existence of a risk premium. The empirical evidence of a risk premium may be culled from a variety of different types of studies. For example, tests of whether uncovered interest parity (UIP) has held during the recent float (see C hapter 11) have lent mixed support to the existence of a risk premium. Thus we saw that although researchers who regress the UIP relationship on asset stocks (regarded as significant determ inants of risk) failed to unearth a risk premium , other tests of the U IP relationship, such as the error orthogonality and unbiasedness tests, tended to cast some doubt on the joint hypothesis of U IP and rational expectations. But the failure of the joint hypothesis could be due, as suggested by Frankel and Froot (1985), to the irrationality of expectations.