International Risk-Sharing and the Transmission of Productivity Shocks

Abstract

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.

A Habit‐Based Explanation of the Exchange Rate Risk Premium

“…Backus and Smith (1993) find that the actual correlation between exchange rate changes and consumption growth rates is low and often negative. Chari, Kehoe, and McGrattan (2002), Corsetti, Dedola, and Leduc (2008), and Benigno and Thoenissen (2008) confirm their findings. Backus and Smith (1993) note that in complete markets and with power utility, the change in real exchange rates is equal to relative consumption growth in two countries multiplied by the risk‐aversion coefficient .…”

International Risk Sharing and the Transmission of Productivity Shocks

“…Consistent with our analytical results in Section 3, the quantitative model can match the volatility of the U.S. RER for two values of the elasticity ω , implying different international transmission mechanisms in response to productivity shocks (see Corsetti, Dedola and Leduc, 2004). However, the model’s ability to generate a negative Backus–Smith correlation with a negative transmission mechanism turns out to be robust to estimating ω based only on the first two moments of our list.…”

“…25 25 The impulse responses to a technology shock to tradables are analysed in details in Corsetti et al (2004). …”

“…31 31 In the working paper version (Corsetti et al , 2004) we also analyse whether the Backus–Smith anomaly could be accounted for by Balassa–Samuelson effects, linking exchange‐rate fluctuations to movements in the relative price of non‐tradables, with negative results. …”

Asset Prices, News Shocks, and the Trade Balance

“…Taking the model structure and the model‐based impulse responses seriously, the negative reaction of the trade balance in the United States indicates the existence of substitutability between domestic and foreign goods. At the same time, the appreciation of the exchange rate and inflation following a news shocks hints toward the dominance of a relative wealth effects following anticipated news about future productivity, as discussed for unanticipated current productivity shocks by Corsetti, Dedola, and Leduc ()…”