A central puzzle in international finance is that real exchange rates are volatile and, in stark contradiction to efficient risk-sharing, negatively correlated with crosscountry consumption ratios. This paper shows that a standard international business cycle model with incomplete asset markets augmented with distribution services can account quantitatively for these properties of real exchange rates. Distribution services, intensive in local inputs, drive a wedge between producer and consumer prices, thus lowering the impact of terms-of-trade changes on optimal agents' decisions. This reduces the price elasticity of tradables separately from assumptions on preferences. Two very different patterns of the international transmission of positive technology shocks generate the observed degree of risk-sharing: one associated with improving, the other with deteriorating terms of trade and real exchange rate. In both cases, large equilibrium swings in international relative prices magnify consumption risk due to country-specific shocks, running counter to risk sharing. Suggestive evidence on the effect of productivity changes in U.S. manufacturing is found in support of the first transmission pattern, questioning the presumption that terms-of-trade movements in response to supply shocks invariably foster international riskpooling.

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This paper shows that standard international business cycle models can be reconciled with the empirical evidence on the lack of consumption risk sharing. First, we show analytically that with incomplete asset markets productivity disturbances can have large uninsurable effects on wealth, depending on the value of the trade elasticity and shock persistence. Second, we investigate these findings quantitatively in a model calibrated to the U.S. economy. With the low trade elasticity estimated via a method of moments procedure, the consumption risk of productivity shocks is magnified by high terms of trade and real exchange rate (RER) volatility. Strong wealth effects in response to shocks raise the demand for domestic goods above supply, crowding out external demand and appreciating the terms of trade and the RER. Building upon the literature on incomplete markets, we then show that similar results are obtained when productivity shocks are nearly permanent, provided the trade elasticity is set equal to the high values consistent with micro-estimates. Under both approaches the model accounts for the low and negative correlation between the RER and relative (domestic to foreign) consumption in the data-the "Backus-Smith puzzle". Copyright 2008 The Review of Economic Studies Limited.

4Non-technical summary 56 Concluding remarks 33Abstract This paper estimates the effects of technology shocks in VAR models of the U.S., identified by imposing restrictions on the sign of impulse responses. These restrictions are consistent with the implications of a popular class of DSGE models, with both real and nominal frictions, and with sufficiently wide ranges for their parameterers. This identification strategy thus substitutes theoretically-motivated restrictions for the atheoretical assumptions on the time-series properties of the data that are key to long-run restrictions. Stochastic technology improvements persistently increase real wages, consumption, investment and output in the data; hours worked are very likely to increase, displaying a hump-shaped pattern. Contrary to most of the related VAR evidence, resultsare not sensitive to a number of specification assumptions, including those on the stationarity properties of variables. JEL classification: C3, E3An important task of macroeconomics is to develop models that account for specific, quantitative features of the business cycle. Modern business cycle theory envisions a central role of random fluctuations in technological progress in driving the bulk of aggregate fluctuations. When technology shocks as volatile and persistent as estimated total factor productivity (TFP) are fed through a standard real business cycle (RBC) model, the simulated economy appears to be able to replicate the patterns of volatilities and cross-correlations of key macroeconomic time series of the postwar U.S. economy. This is a remarkable result for alternative, demand-driven theories have a much harder time in generating key business cycle facts like the strong unconditional procyclicality of both labor productivity and hours worked.The notion that technology shocks have anything to do with business cycles, however, has been recently questioned by a growing literature that aims at testing the predictions of the theory in terms of conditional moments in the data, i.e. conditional on technology shocks being the source of fluctuations, rather than the moments analyzed by RBC models. The key difficulty is that technology shocks need to be identified in the data. The seminal contribution by Galí [1999] originally identified technology shocks with time-series methods as the only source of long-run movements in labor productivity.His results show that a positive technology shock induces a fall in hours worked so persistent that a negative conditional correlation between output and hours worked ensues. Initially the literature reached conclusions similar to Galí [1999]. As stressed by this author, not only does this evidence, taken at face value, reject a key prediction of standard RBC theory, but it highlights a feature of the economy's response to aggregate technology shocks whose relevance goes beyond any specific macroeconomic paradigm. Because of the procyclicality of hours worked, some other shock(s) rather than technology shocks must be driving observed aggregate fluctuat...