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Real Exchange Variability in a Two-Country Business Cycle Model

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  • Hakon Tretvoll

    (BI Handelshoyskolen)

Abstract

This paper shows that introducing recursive preferences in a standard two-country business cycle model implies a real exchange rate as volatile as in the data. With recursive preferences the marginal utility of consumption today depends on innovations in future utilities. Productivity shocks with a unit root have long-term effects and home bias implies that the effects differ across countries. A positive shock in one country therefore leads to a larger drop in marginal utility in that country. There is then a strong depreciation of the real exchange rate and resources are transferred abroad due to risk-sharing between households. This leads to a volatile real exchange rate and can imply positive cross-country correlations in both investment and employment. Innovations to future utilities imply volatile stochastic discount factors which is necessary to price financial assets. The paper therefore bridges the gap between models in international macroeconomics and finance. (Copyright: Elsevier)

Suggested Citation

  • Hakon Tretvoll, 2018. "Real Exchange Variability in a Two-Country Business Cycle Model," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 27, pages 123-145, January.
  • Handle: RePEc:red:issued:13-34
    DOI: 10.1016/j.red.2017.11.006
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    2. Michael Donadelli & Patrick Grüning & Aurelija Proskute, 2019. "Monetary policy, trade, and endogenous growth under different international financial market structures," Bank of Lithuania Working Paper Series 57, Bank of Lithuania.

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    More about this item

    Keywords

    International business cycles; Recursive preferences; Real exchange rate dynamics; Home bias;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles

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