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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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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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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, Central Bank of Chile 597, Central Bank of Chile.
  2. J�n Steinsson, 2008. "The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models," American Economic Review, American Economic Association, American Economic Association, vol. 98(1), pages 519-33, March.
  3. A. Craig Burnside & Jeremy J. Graveline, 2012. "On the Asset Market View of Exchange Rates," NBER Working Papers 18646, National Bureau of Economic Research, Inc.
  4. Donadelli, Michael & Paradiso, Antonio, 2014. "Does financial integration affect real exchange rate volatility and cross-country equity market returns correlation?," The North American Journal of Economics and Finance, Elsevier, Elsevier, vol. 28(C), pages 206-220.
  5. Michael B Devereux & Gregor W Smith & James Yetman, 2009. "Consumption and real exchange rates in professional forecasts," BIS Working Papers 295, Bank for International Settlements.
  6. Guglielmo Maria Caporale & Michael Donadelli & Alessia Varani, 2014. "International Capital Markets Structure, Preferences and Puzzles: The US-China Case," Discussion Papers of DIW Berlin 1362, DIW Berlin, German Institute for Economic Research.
  7. M. Hadzi-Vaskov, 2008. "Does the nominal exchange rate explain the Backus-Smith puzzle? evidence from the Eurozone," Working Papers, Utrecht School of Economics 07-32, Utrecht School of Economics.
  8. Nuntramas, Phacharaphot, 2011. "Revisiting the consumption-real exchange rate anomaly in a model with non-traded goods," Journal of International Money and Finance, Elsevier, Elsevier, vol. 30(3), pages 428-447, April.

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