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Real exchange rate variability in a two country business cycle model


  • Hakon Tretvoll

    (New York University)


Real exchange rate fluctuations have important implications for our understanding of the sources and transmission of international business cycles, and the degree of international risk sharing. In most two-country business cycle models, the real exchange rate is determined by differences in consumption and leisure across countries, and its standard deviation is significantly smaller than we see in the data. With recursive preferences the marginal utility of consumption today also depends on innovations in agents' future utilities. Real exchange rate movements are therefore partially disconnected from current quantities. With permanent cointegrated technology shocks and home bias, the model generates realistic variability in the real exchange rate. The mechanism is similar to related work on asset pricing, and the model produces highly volatile stochastic discount factors with more realistic asset pricing implications. In addition, there is modest improvement in the cross-country correlations of quantities, as investment and employment are positively correlated across countries.

Suggested Citation

  • Hakon Tretvoll, 2012. "Real exchange rate variability in a two country business cycle model," 2012 Meeting Papers 911, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:911

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    References listed on IDEAS

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    Cited by:

    1. Hakon Tretvoll, 2013. "Investment-Specific Technology Shocks and Recursive Preferences," 2013 Meeting Papers 1207, Society for Economic Dynamics.
    2. Grüning, Patrick, 2015. "International endogenous growth, macro anomalies, and asset prices," SAFE Working Paper Series 83, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    3. Irina Zviadadze, 2014. "Term-structure of consumption risk premia in the cross-section of currency returns," 2014 Meeting Papers 1075, Society for Economic Dynamics.
    4. Backus, David & Coleman, Chase & Ferriere, Axelle & Lyon, Spencer, 2016. "Pareto weights as wedges in two-country models," Journal of Economic Dynamics and Control, Elsevier, vol. 72(C), pages 98-110.

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