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Does the Nominal Exchange Rate Explain the Backus-Smith Puzzle? Evidence from the Eurozone

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Author Info
Metodij Hadzi-Vaskov ()

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Abstract

The negative correlation between relative consumption growth and real exchange rate changes is a recurrent puzzle in international macroeconomics (Backus and Smith, 1993). Using panel dataset with quarterly observations for all 12 countries from the Eurozone after the introduction of the common currency (1999-2006), this paper demonstrates that the nominal exchange rate is the main source of the puzzle. When nominal exchange rates fluctuations are eliminated, relative consumption growth is positively correlated with the change in the real exchange rate. Moreover, this result is contrasted with alternative samples of (relatively) flexible exchange rate: while the inflation differential is still positively correlated, the nominal exchange rate is negatively correlated with the relative consumption growth. These findings are robust to alternative regression specifications, estimation methods, and data samples.

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Paper provided by Utrecht School of Economics in its series Working Papers with number 07-32.

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Length: 46 pages
Date of creation: Mar 2008
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Handle: RePEc:use:tkiwps:0732

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Keywords: International Risk-Sharing; Exchange Rates; Backus-Smith Puzzle;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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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. 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)
  2. Hess, Gregory & Shin, Kwanho, 2006. "Understanding the Backus-Smith Puzzle: It’s the (Nominal) Exchange Rate, Stupid," MPRA Paper 696, University Library of Munich, Germany. [Downloadable!]
  3. Engel, Charles & Rogers, John H, 1996. "How Wide Is the Border?," American Economic Review, American Economic Association, vol. 86(5), pages 1112-25, December. [Downloadable!] (restricted)
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  4. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June. [Downloadable!] (restricted)
  5. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Blackwell Publishing, vol. 69(3), pages 533-63, July.
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  6. Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2004. "International Risk Sharing and the Transmission of Productivity Shocks," CEPR Discussion Papers 4746, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  7. Martin Bodenstein, 2005. "International Asset Markets and Real Exchange Rate Volatility," 2005 Meeting Papers 352, Society for Economic Dynamics. [Downloadable!]
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  8. Flood, Robert P & Rose, Andrew K, 1999. "Understanding Exchange Rate Volatility without the Contrivance of Macroeconomics," Economic Journal, Royal Economic Society, vol. 109(459), pages F660-72, November. [Downloadable!] (restricted)
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  9. Ravn, Morten O., 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  10. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-75, August. [Downloadable!] (restricted)
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  11. Cochrane, John H, 1991. "A Simple Test of Consumption Insurance," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 957-76, October. [Downloadable!] (restricted)
  12. Christoph Thoenissen, 2006. " Real Exchange Rate Volatility and Asset Market Structure," CDMA Working Paper Series 0609, Centre for Dynamic Macroeconomic Analysis, revised Oct 2006. [Downloadable!]
  13. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  14. Gianluca Benigno & Christoph Thoenissen, . "On the consumption-real exchange rate anomaly," Bank of England working papers 254, Bank of England. [Downloadable!]
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  15. Christoph Thoenissen & Gianluca Benigno, 2004. "The consumption-real exchange rate anomaly," Money Macro and Finance (MMF) Research Group Conference 2003 102, Money Macro and Finance Research Group. [Downloadable!]
  16. Kollmann, R., 1992. "Consumption, Real Exchange Rates and the Structure of International Asset Markets," Cahiers de recherche 9232, Universite de Montreal, Departement de sciences economiques.
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Cited by:
(explanations, 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. 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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