Understanding the Backus-Smith Puzzle: It’s the (Nominal) Exchange Rate, Stupid
Backus, Kehoe and Kydland (BKK 1992) showed that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus and Smith (1993) showed that there is an additional impediment that works to lower the consumption growth correlation. While Backus and Smith’s argument was successful in partially explaining the low growth correlation puzzle, it contributed to generating another puzzle because the data forcefully showed that consumption growth is negatively correlated with the real exchange rate, which is a violation of the theory. In this paper, by decomposing the real exchange rate growth of the OECD countries into the nominal exchange rate growth and the inflation differential, we find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We find that the nominal exchange rate moves counter-cyclically with consumption movements, which is a violation of the risk sharing theory with non-traded goods. We also find that the violations are more pronounced when nominal exchange rate changes are larger in absolute value . In contrast, the negative of bilateral inflation differentials is positively correlated with bilateral consumption movements. The latter finding is in accordance with the theory. Furthermore, using intranational data for the United States where the nominal exchange rate is constant, the Backus-Smith puzzle disappears, although complete risk sharing is rejected.
|Date of creation:||Feb 2006|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: https://mpra.ub.uni-muenchen.de
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Canova, Fabio & Ravn, Morten O, 1994.
"International Consumption Risk Sharing,"
CEPR Discussion Papers
1074, C.E.P.R. Discussion Papers.
- Del Negro, Marco, 2002.
"Asymmetric shocks among U.S. states,"
Journal of International Economics,
Elsevier, vol. 56(2), pages 273-297, March.
- David K. Backus & Gregor W. Smith, 1993.
"Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods,"
1252, Queen's University, Department of Economics.
- Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November.
- Hess, Gregory D. & Shin, Kwanho, 1998.
"Intranational business cycles in the United States,"
Journal of International Economics,
Elsevier, vol. 44(2), pages 289-313, April.
- Gregory D. Hess & Kwanho Shin, 1995. "Intranational business cycles in the United States," Research Working Paper 95-07, Federal Reserve Bank of Kansas City.
- David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987.
"International real business cycles,"
426, Federal Reserve Bank of Minneapolis.
- Martin Feldstein & Charles Horioka, 1979.
"Domestic Savings and International Capital Flows,"
NBER Working Papers
0310, National Bureau of Economic Research, Inc.
- Bent E. Sørensen & Oved Yosha, 1996.
"Income and Consumption Smoothing among US States: Regions or Clubs?,"
96-13, University of Copenhagen. Department of Economics.
- Sørensen, Bent E & Yosha, Oved, 1997. "Income and Consumption Smoothing Among US States: Regions or Clubs?," CEPR Discussion Papers 1670, C.E.P.R. Discussion Papers.
- Sorensen, B.E. & Yosha, O., 1996. "Income and ConsumptionSmoothing Among U.S. States : Regions or Clubs?," Papers 19-96, Tel Aviv.
- Mace, Barbara J, 1991. "Full Insurance in the Presence of Aggregate Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 99(5), pages 928-56, October.
- Mario J. Crucini, 1999. "On International and National Dimensions of Risk Sharing," The Review of Economics and Statistics, MIT Press, vol. 81(1), pages 73-84, February.
- Lewis, Karen K, 1996. "What Can Explain the Apparent Lack of International Consumption Risk Sharing?," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 267-97, April.
- Hess, Gregory D. & Shin, Kwanho, 2000.
"Risk sharing by households within and across regions and industries,"
Journal of Monetary Economics,
Elsevier, vol. 45(3), pages 533-560, June.
- Gregory D. Hess & Kwanho Shin, 1997. "Risk sharing by households within and across regions and industries," Research Working Paper 97-07, Federal Reserve Bank of Kansas City.
- Ravn, Morten O, 2001. "Consumption Dynamics and Real Exchange Rate," CEPR Discussion Papers 2940, C.E.P.R. Discussion Papers.
When requesting a correction, please mention this item's handle: RePEc:pra:mprapa:696. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Ekkehart Schlicht)
If references are entirely missing, you can add them using this form.