On the foreign exchange risk premium in a general equilibrium model

The foreign exchange risk premium in a cash-in-advance model is investigated. Some weaknesses of the detinition of the risk premium generally used are discussed. It is shown that the primary ultimate source of foreign exchange risk is the covariance of monetary shocks with real output shocks. Several studies have assumed this covariance is zero, and hence assumed away the major source of risk in the model. Finally, the risk premium generated from standard versions of this model is argued to be very small, because it is the same order of magnitude as covariances of money and output growth rates.