International Consumption Risk Sharing and Trade Transaction Costs

This paper investigates the implications of international consumption risk sharing for a panel 69 developed and developing countries over the period 1986-2006. We theoretically derive the international consumption insurance proposition within an international real business cycle setup that involves consumption correlation with the real exchange rate to incorporate salient features that impede consumption risk sharing, namely trade costs and capital market imperfections, making use of the gravity structural model to obtain the trade costs estimates and output volatility to proxy capital market imperfections. We analyze the implications of the theory based on panel data estimation. We find that trade costs significantly impede risk sharing for the aggregate sample of countries and a 10% increase in trade costs can decrease consumption by almost 0:7% and 0:6% for trade between developed and developing countries and for intra-developing country trade respectively while intra-developed country trade seems to be affected by temporary changes in trade costs. Developed countries seem to be in line with insuring against output volatility while low income group face asset market constraints as output uncertainty increases. Policy implication hence involves lowering international trade costs in an attempt to alleviate issues of consumption allocations.