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The Backus-Smith Puzzle: The Role of Expectations

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  • Luis Opazo

Abstract

Efficient risk-sharing dictates a positive relationship between the real exchange rate and relative consumption across countries: consumption should be relatively high where consumption is relatively cheap. However, contrary to the positive relationship predicted by most models, the empirical correlation between bilateral real exchange rates and relative consumptions is typically negative (see Backus and Smith, 1993). In this paper I extend a standard two-country, two-good international business cycle model with internationally incomplete financial markets to incorporate public signals about future innovations to total factor productivity. In this environment, a positive signal increases the relative present value of domestic lifetime income, implying that current consumption can increase by more than current output. This increase in demand in turn generates an appreciation in the real exchange rate, suggesting a potential resolution to the Backus-Smith puzzle. When the economy is calibrated to the United States versus the rest of the industrialized world, numerical simulations deliver a correlation between the exchange rate and relative consumption that is similar to that observed empirically.

Suggested Citation

  • Luis Opazo, 2006. "The Backus-Smith Puzzle: The Role of Expectations," Working Papers Central Bank of Chile 395, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:395
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    1. Hedging Income Fluctuations with Foreign Currency Assets
      by Blog Author in Liberty Street Economics on 2016-01-06 18:00:00

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    Cited by:

    1. Giancarlo Corsetti & Luca Dedola & Francesca Viani, 2012. "Traded and Nontraded Goods Prices, and International Risk Sharing: An Empirical Investigation," NBER International Seminar on Macroeconomics, University of Chicago Press, vol. 8(1), pages 403-466.
    2. Nam, Deokwoo & Wang, Jian, 2015. "The effects of surprise and anticipated technology changes on international relative prices and trade," Journal of International Economics, Elsevier, vol. 97(1), pages 162-177.
    3. Robert Kollmann, 2012. "Limited asset market participation and the consumption-real exchange rate anomaly," Canadian Journal of Economics, Canadian Economics Association, vol. 45(2), pages 566-584, May.
    4. Predrag Petrović, 2016. "Backus–Smith puzzle and the European Union: It’s not just the nominal exchange rate," Zbornik radova Ekonomskog fakulteta u Rijeci/Proceedings of Rijeka Faculty of Economics, University of Rijeka, Faculty of Economics, vol. 34(2), pages 393-418.
    5. De Paoli, Bianca & Küçük, Hande, 2015. "News shocks, monetary policy, and foreign currency positions," Staff Reports 750, Federal Reserve Bank of New York.
    6. Kyriacos Lambrias, 2013. "News Shocks, Real Exchange Rates and International Co-Movements," BCL working papers 83, Central Bank of Luxembourg.
    7. Devereux, Michael B. & Smith, Gregor W. & Yetman, James, 2012. "Consumption and real exchange rates in professional forecasts," Journal of International Economics, Elsevier, vol. 86(1), pages 33-42.
    8. Gianluca Benigno & Hande Küçük, 2012. "Portfolio allocation and international risk sharing," Canadian Journal of Economics, Canadian Economics Association, vol. 45(2), pages 535-565, May.
    9. Hamano, Masashige, 2013. "The consumption-real exchange rate anomaly with extensive margins," Journal of International Money and Finance, Elsevier, vol. 36(C), pages 26-46.
    10. Stijn Claessens & M Ayhan Kose, 2017. "Asset prices and macroeconomic outcomes: a survey," BIS Working Papers 676, Bank for International Settlements.
    11. Daniele Siena, 2017. "What's News in International Business Cycles," 2017 Meeting Papers 1206, Society for Economic Dynamics.
    12. Lambrias, Kyriacos, 2016. "Real exchange rates and international co-movement: news-shocks and non-tradable goods with complete markets," Working Paper Series 1946, European Central Bank.

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