Fama’s (1984) volatility relations show that the risk premium in foreign exchangemarkets is more volatile than, and is negatively correlated with the expected rate ofdepreciation. This paper studies these relations from the perspective of goods marketsfrictions. Using a sticky-price general equilibrium model, we show that near-randomwalk behaviors of both exchange rates and consumption, in response to monetaryshocks, can be derived endogenously. Based on this approach, the paper providesquantitative results that might explain the forward premium anomaly, which is one ofthe most important puzzles in international finance.
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