THE USE OF THE EXCHANGE-RATE FOR STABILIZATION - A REAL INTEREST ARBITRAGE MODEL APPLIED TO ARGENTINA

We model interest rate and portfolio determination under the risk of r eal currency devaluation taking into account risk aversion on the part of investors. A simple extension of the Friedman-Savage analysis of c onsumer behavior under uncertainty to a two period, two country settin g allows us to explicitly solve for the interest rate premium paid in the risky asset. The model is applied to the 1979-80 Argentinean exper iment with the preannounced exchange rate. Empirical results suggest t hat a safety factor, central bank reserves as a fraction of M2, is clo sely related to the net ex ante and ex post arbitrage differentials in favor of Argentina relative to the United States.