RDP8906 A Random Walk Around the $A: Expectations, Risk, Interest Rates and Consequences for External Imbalance

Abstract

Given essentially perfect capital mobility, Australian interest rates and the expected exchange rate change should satisify international arbitrage conditions. We examine an arbitrage condition for a US investor, with a view to explaining the large short-term real interest differential between Australia and the US since late 1984. We have some evidence for a risk premium until late 1985. Since then, we explain the differential as a result of foreign exchange market inefficiency or as a consequence of the market having continually and rationally expected significant real devaluation of the $A. We provide evidence for both these explanations and draw implications for the current debate on Australia’s external imbalance.

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