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Understanding the Backus-Smith puzzle: It's the (nominal) exchange rate, stupid

  • Hess, Gregory D.
  • Shin, Kwanho

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3-4), 297-316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to 'rule of thumb' consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.

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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 1 (February)
Pages: 169-180

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:1:p:169-180
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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  1. Marco Del Negro, 1999. "Asymmetric shocks among U.S. states," Working Papers 9903, Centro de Investigacion Economica, ITAM.
  2. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
  3. Gregory D. Hess & Kwanho Shin, 1997. "Risk sharing by households within and across regions and industries," Research Working Paper 97-07, Federal Reserve Bank of Kansas City.
  4. Canova, Fabio & Ravn, Morten O, 1996. "International Consumption Risk Sharing," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 37(3), pages 573-601, August.
  5. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, vol. 90(358), pages 314-29, June.
  6. Ravn, Morten O, 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers.
  7. David K. Backus & Gregor W. Smith, 1993. "Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods," Working Papers 1252, Queen's University, Department of Economics.
  8. Mace, Barbara J, 1991. "Full Insurance in the Presence of Aggregate Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 928-56, October.
  9. Gregory D. Hess & Kwanho Shin, 1995. "Intranational business cycles in the United States," Research Working Paper 95-07, Federal Reserve Bank of Kansas City.
  10. Mario J. Crucini, 1999. "On International and National Dimensions of Risk Sharing," The Review of Economics and Statistics, MIT Press, vol. 81(1), pages 73-84, February.
  11. Lewis, Karen K, 1996. "What Can Explain the Apparent Lack of International Consumption Risk Sharing?," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 267-97, April.
  12. Bent E. Sørensen & Oved Yosha, 1996. "Income and Consumption Smoothing among US States: Regions or Clubs?," Discussion Papers 96-13, University of Copenhagen. Department of Economics.
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