Risk sharing and real exchange rates: the role of non-tradable sector and trend shocks

Most of the international macro models, in contrast to the data, imply a very high level of risk sharing across countries and very low real exchange rate (RER) volatility relative to output. In this paper we show that a standard two-country two-good model augmented with conintegrated TFP processes comes closer to matching the data. We first show that the tradable and non-tradable total factor productivity (TFP) processes of the US and Europe have unit roots and can be modelled by a vector error correction model (VECM). Then, we develop a standard two-country and two-good (tradable and non-tradable) DSGE model and study the quantitative implications. Cointegrated TFP shocks, or trend shocks, generate significant income effects and amplify the mechanisms that produce high RER volatility. Moreover, trend shocks can break the tight link between relative consumption and RER for low and high values of trade elasticity parameters.