Could you give an explanation why that is :)? I know that a first order solution is equivalent to a perfect foresight one due to certainty equivalence, but I am not sure, what difference does it make for this equation. Any intuiton or explanation would be very much appreciated… Thanks for all your time and answers.
Ben
The second order approximation would include covariance terms.
E(X,Y)= E(X)E(Y) + Cov(X,Y)
The Cov() term would be omitted in a first order approximation.
Hello Reuben,
I have another (probably very stupid) question. Given the UIP condition scetched above (i.e. the ratio of the two interest rates determines the growth rate of the nominal exchange rate (i.e. 1+\Delta{NEER_{t+1}}), how is the initial response (in period t) of the nominal exchange rate determined? Wouldnt \Delta NEER_{t} depend on the ratio of the initial conditions/steady state interest rates? I am a bit puzzled.
A rise in the home interest rate will lead to an immediate appreciation of the home currency, because the demand for the home currency denominated bonds will increase. But then the home currency will be expected to depreciate, because otherwise the investor would not be indifferent between the home and foreign currency denominated bonds. The no arbitrage condition would be violated. This would be true of any steady-state value. The currency would be expected to depreciate in the context of the neoclassical model.