International Risk Sharing with Heterogeneous Firms

Little is known about the consequence of firm heterogeneity and its resulting reallocation effect on international consumption risk sharing. This paper explores international risk sharing in a theoretical model with firm heterogeneity and shows that firm heterogeneity changes the nature of international risk sharing, thus driving a wedge between relative consumption growth and real exchange rate fluctuations. A correlation is found to be conditional on the fluctuations in the number of product varieties and their qualities arising from the reallocation effect induced by heterogeneous firms; the conventional unconditional correlation can be thus biased. Using world trade data covering more than two decades, I note the existence of bias and find that the extent of international risk sharing is underestimated. The analysis indicates a larger welfare gain from international trade than we have been measuring.