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The Backus-Smith Puzzle: The Role of Expectations

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Luis Opazo

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Abstract

Efficient risk-sharing dictates a positive relationship between the real exchange rate and relative consumption across countries: consumption should be relatively high where consumption is relatively cheap. However, contrary to the positive relationship predicted by most models, the empirical correlation between bilateral real exchange rates and relative consumptions is typically negative (see Backus and Smith, 1993). In this paper I extend a standard two-country, two-good international business cycle model with internationally incomplete financial markets to incorporate public signals about future innovations to total factor productivity. In this environment, a positive signal increases the relative present value of domestic lifetime income, implying that current consumption can increase by more than current output. This increase in demand in turn generates an appreciation in the real exchange rate, suggesting a potential resolution to the Backus-Smith puzzle. When the economy is calibrated to the United States versus the rest of the industrialized world, numerical simulations deliver a correlation between the exchange rate and relative consumption that is similar to that observed empirically.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 395.

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Date of creation: Dec 2006
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Handle: RePEc:chb:bcchwp:395

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1993. "International Business Cycles: Theory and Evidence," Working Papers 93-21, New York University, Leonard N. Stern School of Business, Department of Economics.
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  2. William Easterly & Ross Levine, 2002. "It's Not Factor Accumulation: Stylized Facts and Growth Models," Working Papers Central Bank of Chile 164, Central Bank of Chile. [Downloadable!]
  3. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November. [Downloadable!] (restricted)
  4. Arvanitis, Athanasios V & Mikkola, Anne, 1996. "Asset-Market Structure and International Trade Dynamics," American Economic Review, American Economic Association, vol. 86(2), pages 67-70, May. [Downloadable!] (restricted)
  5. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2003. "International risk-sharing and the transmission of productivity shocks," Working Papers 03-19, Federal Reserve Bank of Philadelphia. [Downloadable!]
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  6. Teresa Santero & Niels Westerlund, 1996. "Confidence Indicators and Their Relationship to Changes in Economic Activity," OECD Economics Department Working Papers 170, OECD, Economics Department. [Downloadable!]
  7. Nicholas S. Souleles, 2001. "Consumer Sentiment: Its Rationality and Usefulness in Forecasting Expenditure - Evidence from the Michigan Micro Data," NBER Working Papers 8410, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Danthine, Jean-Pierre & Donaldson, John B. & Johnsen, Thore, 1998. "Productivity growth, consumer confidence and the business cycle," European Economic Review, Elsevier, vol. 42(6), pages 1113-1140, June. [Downloadable!] (restricted)
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  9. Daron Acemoglu & Jaume Ventura, 2001. "The World Income Distribution," NBER Working Papers 8083, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February. [Downloadable!] (restricted)
  11. Stockman, Alan C & Tesar, Linda L, 1995. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," American Economic Review, American Economic Association, vol. 85(1), pages 168-85, March. [Downloadable!] (restricted)
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  12. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 507-538, June. [Downloadable!] (restricted)
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  13. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1992. "Relative Price Movements in Dynamic General Equilibrium Models of International Trade," Working Papers 92-25, New York University, Leonard N. Stern School of Business, Department of Economics.
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  14. Baxter, Marianne & Crucini, Mario J, 1995. "Business Cycles and the Asset Structure of Foreign Trade," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(4), pages 821-54, November. [Downloadable!] (restricted)
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  15. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August. [Downloadable!] (restricted)
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  16. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA. [Downloadable!]
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  17. Acemoglu, Daron & Scott, Andrew, 1994. "Consumer Confidence and Rational Expectations: Are Agents' Beliefs Consistent with the Theory?," Economic Journal, Royal Economic Society, vol. 104(422), pages 1-19, January. [Downloadable!] (restricted)
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  18. Heathcote, Jonathan & Perri, Fabrizio, 2002. "Financial autarky and international business cycles," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 601-627, April. [Downloadable!] (restricted)
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  19. Ravn, Morten O., 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  20. Batchelor, Roy & Dua, Pami, 1992. "Survey Expectations in the Time Series Consumption Function," The Review of Economics and Statistics, MIT Press, vol. 74(4), pages 598-606, November. [Downloadable!] (restricted)
  21. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 223, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  22. Jorge Selaive & Vicente Tuesta, 2003. "Net Foreign Assets And Imperfect Financial Integration: An Empirical Approach," Working Papers Central Bank of Chile 252, Central Bank of Chile. [Downloadable!]
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  23. Jorge Selaive & Vicente Tuesta, 2003. "Net foreign assets and imperfect pass-through: the consumption real exchange rate anomaly," International Finance Discussion Papers 764, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  1. Michael B. Devereux & Gregor W. Smith & James Yetman, 2009. "Consumption and Real Exchange Rates in Professional Forecasts," NBER Working Papers 14795, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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