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Why Are Exchange Rates So Smooth? A Household Finance Explanation

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Abstract

Empirical moments of asset prices and exchange rates imply that pricing kernels are almost perfectly correlated across countries. Otherwise, observed real exchange rates would be too smooth for high Sharpe ratios. However, the cross country correlation among macro fundamentals is weak. We reconcile these facts in a two-country stochastic growth model with heterogeneous households and a home bias in consumption. In our model, only a small fraction of households trade domestic and foreign equities. We show that this mechanism can quantitatively account for the smoothness of exchange rates in the presence of volatile pricing kernels and weakly correlated macro fundamentals.

Suggested Citation

  • YiLi Chien & Hanno Lustig & Kanda Naknoi, "undated". "Why Are Exchange Rates So Smooth? A Household Finance Explanation," Working Papers 2015-039, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:2015-039
    DOI: 10.1016/j.jmoneco.2019.02.003
    Note: Previous title: Why Are Exchange Rates So Smooth? A Segmented Asset Markets Explanation
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    References listed on IDEAS

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    1. Yili Chien & Harold Cole & Hanno Lustig, 2011. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," Review of Economic Studies, Oxford University Press, vol. 78(1), pages 199-234.
    2. Emmanuel Farhi & Xavier Gabaix, "undated". "Rare Disasters and Exchange Rates," Working Paper 71001, Harvard University OpenScholar.
    3. Warnock, Francis E., 2003. "Exchange rate dynamics and the welfare effects of monetary policy in a two-country model with home-product bias," Journal of International Money and Finance, Elsevier, vol. 22(3), pages 343-363, June.
    4. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153-181.
    5. Doireann Fitzgerald, 2012. "Trade Costs, Asset Market Frictions, and Risk Sharing," American Economic Review, American Economic Association, vol. 102(6), pages 2700-2733, October.
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    Cited by:

    1. Adrien Verdelhan & Hanno Lustig, 2016. "Does Incomplete Spanning in International Financial Markets Help to Explain Exchange Rates?," 2016 Meeting Papers 1183, Society for Economic Dynamics.
    2. Anella Munro, 2016. "Bond premia, monetary policy and exchange rate dynamics," Reserve Bank of New Zealand Discussion Paper Series DP2016/11, Reserve Bank of New Zealand.

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    More about this item

    Keywords

    International risk sharing; Asset pricing; Exchange rates; Market segmentation;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • F10 - International Economics - - Trade - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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