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News Shocks, Real Exchange Rates and International Co-Movements

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  • Kyriacos Lambrias

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Abstract

We propose a fully flexible, complete-market model of the international business cycle that is consistent with two major empirical facts: positive cross-country co-movement of economic aggregates and a negative correlation between the real exchange rate and relative consumption (the Backus-Smith puzzle). The model features non-tradable goods, zero wealth effects on labour supply, imperfect substitutability of capital across sectors and variable capacity utilisation. The latter can generate strong Balassa-Samuelson effects that drive a low consumption-real exchange rate correlation. Cyclical movements across countries are also positively correlated. The novelty of our paper is to introduce changes in expectations (news-shocks) as an explanation to the Backus-Smith puzzle through the wealth effects of future changes in income, while being consistent with expectations-driven economic expansions.

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Bibliographic Info

Paper provided by Central Bank of Luxembourg in its series BCL working papers with number 83.

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Length: 46 pages
Date of creation: Jul 2013
Date of revision:
Handle: RePEc:bcl:bclwop:bclwp083

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Web page: http://www.bcl.lu/

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Keywords: News-Driven Cycles; Backus-Smith Puzzle; Real-Exchange Rates;

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