Revisiting the consumption-real exchange rate anomaly in a model with non-traded goods

This paper shows that the assumption used in many two-country business cycle models that all non-traded goods are nondurable consumption goods magnifies the severity of the consumption-real exchange rate anomaly, which is the discrepancy between the high correlation between relative consumption and the real exchange rate predicted by most models and the low correlation observed empirically. This assumption hampers the ability to generate wealth effects necessary for the economies to deviate away from full risk-sharing. Using an alternative setup in which non-traded goods can also be investment goods improves the ability of the model to generate wealth effects, and therefore to overcome the anomaly.