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International Asset Markets and Real Exchange Rate Volatility

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  • Martin Bodenstein

    (Federal Reserve Board)

Abstract

The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs better than a standard incomplete markets model with a single non-contingent bond unless very tight borrowing constraints are imposed in the latter. With limited enforcement for both domestic and international financial contracts, the model's asset pricing implications are brought into line with the empirical evidence, albeit at the expense of raising real exchange rate volatility. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2007.12.003
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 11 (2008)
Issue (Month): 3 (July)
Pages: 688-705

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Handle: RePEc:red:issued:07-120

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Related research

Keywords: Risk-sharing; Limited enforcement; Real exchange rate; Backus-Smith puzzle; Asset prices;

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References

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Citations

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Cited by:
  1. Andrés Sagner, 2010. "Implied Probability Distribution in Financial Options," Working Papers Central Bank of Chile 597, Central Bank of Chile.
  2. Devereux, Michael B. & Smith, Gregor W. & Yetman, James, 2012. "Consumption and real exchange rates in professional forecasts," Journal of International Economics, Elsevier, vol. 86(1), pages 33-42.
  3. Nuntramas, Phacharaphot, 2011. "Revisiting the consumption-real exchange rate anomaly in a model with non-traded goods," Journal of International Money and Finance, Elsevier, vol. 30(3), pages 428-447, April.
  4. Metodij Hadzi-Vaskov, 2008. "Does the Nominal Exchange Rate Explain the Backus-Smith Puzzle? Evidence from the Eurozone," Working Papers 07-32, Utrecht School of Economics.

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