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Consumption Risk Sharing, the Real Exchange Rate, and Borders: Why Does the Exchange Rate Make Such a Difference?

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  • Viktoria Hnatkovska

    (UBC)

  • Michael Devereux

    (UBC)

Abstract

This paper explores the nature of consumption risk-sharing within and across countries. A basic prediction of efficient risk sharing is that relative consumption growth rates across countries or regions should be positively related to real exchange rate growth rates across the same areas. We provide a comprehensive investigation of this hypothesis in a multi-country and multi-regional data set. Controlling for consumption comparisons across national borders, we find significant evidence of risk sharing. Incorporating the impact of borders, however, relative consumption growth is negatively related to real exchange rate changes. In line with previous work, we find that the border effect is substantially (but not fully) accounted for by nominal exchange rate variability. We then ask whether standard open economy macro models can explain these features of the data. We argue that they cannot. In order to explain the key role of the nominal exchange rate in deviations from cross country consumption risk sharing, it is necessary to combine multiple sources of shocks, both from supply and demand, ex-ante price setting, and incomplete financial markets. The paper develops a model based on these features and investigates its ability to account for the empirical evidence on consumption risk sharing and the role of the nominal exchange rate.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1027.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1027

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  1. Gianluca Benigno & Christoph Theonissen, 2006. "Consumption and real exchange rates with incomplete markets and non-traded goods," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 3758, London School of Economics and Political Science, LSE Library.
  2. Kollmann, Robert, 1995. "Consumption, real exchange rates and the structure of international asset markets," Journal of International Money and Finance, Elsevier, Elsevier, vol. 14(2), pages 191-211, April.
  3. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 123(4), pages 1415-1464, November.
  4. 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, American Economic Association, vol. 85(1), pages 168-85, March.
  5. Robert Kollmann, 2010. "Limited asset market participation and the consumption-real exchange rate anomaly," Globalization and Monetary Policy Institute Working Paper, Federal Reserve Bank of Dallas 41, Federal Reserve Bank of Dallas.
  6. Yohei Okawa & Eric van Wincoop, 2010. "Gravity in International Finance," Working Papers, Hong Kong Institute for Monetary Research 072010, Hong Kong Institute for Monetary 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. Hess, Gregory D. & Shin, Kwanho, 2000. "Risk sharing by households within and across regions and industries," Journal of Monetary Economics, Elsevier, Elsevier, vol. 45(3), pages 533-560, June.
  9. Del Negro, Marco, 2002. "Asymmetric shocks among U.S. states," Journal of International Economics, Elsevier, Elsevier, vol. 56(2), pages 273-297, March.
  10. Michael B. Devereux & Alan Sutherland, 2008. "Country portfolios in open economy macro models," Globalization and Monetary Policy Institute Working Paper, Federal Reserve Bank of Dallas 09, Federal Reserve Bank of Dallas.
  11. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, Elsevier, vol. 35(3-4), pages 297-316, November.
  12. Yuriy Gorodnichenko & Linda L. Tesar, 2009. "Border Effect or Country Effect? Seattle May Not Be So Far from Vancouver After All," American Economic Journal: Macroeconomics, American Economic Association, American Economic Association, vol. 1(1), pages 219-41, January.
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