International Risk Sharing and Financial Shocks

A canonical two-country real business cycle model with complete international asset markets fails to replicate the sign of the correlation between relative consumptions and real exchange rates - i.e. the consumption-real exchange rate anomaly or Backus-Smith puzzle. When preferences are non-separable between consumption and leisure, the same two-country model augmented by domestic financial frictions and shocks can account for the sign of the Backus-Smith correlation. Specifically, shocks to the firms' borrowing capacity create important fluctuations in the labor wedge, inducing firms to demand more labor following these positive financial shocks. These procyclical movements in hours worked significantly affect the marginal utility of consumption and explain the Backus-Smith correlation. Moreover, the same model under financial autarky predicts a correlation that is far away from its empirical counterpart.