Net Foreign Assets and Imperfect Pass-through: The Consumption Real Exchange Rate Anomaly

Abstract

An unresolved issue in international macroeconomics is the apparent lack of risk-sharing across countries, which contradicts the prediction of models based on the assumption of complete markets. We assess the importance of financial frictions in this issue by constructing an incomplete market model with stationary net foreign assets (NFA) and imperfect pass-through (IPT). In this paper, there is a cost of bond holdings that allows us to incorporate the dynamics of NFA into the risk-sharing condition. On theoretical grounds, our results suggest that the dynamics of NFA may account for the lack of risk-sharing across countries. In addition, the IPT mechanism, by closing the current account channel, does not help to explain this feature of the data. On empirical grounds, we test the risk-sharing condition derived in the paper, and we find that growth factors of consumption and real exchange rates behave in a manner that may be consistent with a significant role for the net foreign asset position.

Backus–Smith puzzle and the European Union: It’s not just the nominal exchange rate

“…Firstly, the results of this research which are in favour of presence of Backus-Smith puzzle in 27 EU member states match with most presented papers, since most of them indicate its presence. Secondly, there is partial compatibility of these results and findings presented in a group of papers (Kollmann, 2010;Opazo, 2006;Selaive and Tuesta, 2003), taking into account that they do not challenge the presence of Backus-Smith puzzle, but rather offer certain theoretical explanations for it. Thirdly, although matches can be observed with Hadzi-Vaskov (2008) and Hess and Shin (2010), the main difference from them is that this research did not succeed in locating the nominal exchange rate as the main source of the Backus-Smith puzzle.…”

“…Adjustment of model for the USA economy versus the rest of the industrialised world shows correlation between the real exchange rate and relative consumption, which is quite similar to empirically established correlation. Selaive and Tuesta (2003) tried to solve the Backus-Smith puzzle stressing the importance of international financial frictions. Enriching the previous models with a particular incomplete asset market structure in which the net foreign asset position affects the real exchange rate, they obtain results that the interaction of incomplete markets and imperfect financial integration may deliver very low crosscorrelations between real exchange rate and relative consumptions.…”

A Monetary Model of the Exchange Rate with Informational Frictions

“…I use data for the U.S. Dollar and a synthetic aggregate of the Euro-zone to quantify these moments. However, similar patterns have been consistently uncovered between the U.S. and other major OECD countries (e.g., Chari et al, 2002, Selaive andTuesta, 2003). These facts take their own place among the notable puzzles in international macroeconomics under the tag of the excess volatility-high persistence anomaly.…”

“…Chari et al (2002) replace the assumption of complete international asset markets with a nominal bond economy to break the connection, but they still find a high positive cross-correlation between the real exchange rate and relative consumption unlike that observed in the data 2 . P. Benigno (2001) proposes, instead, an alternative characterization of the bond economy with ad hoc costs of international borrowing (recently applied by Selaive and Tuesta, 2003, and G. Benigno and Thoenissen, 2006, among others). G. Benigno and Thoenissen (2006) explain that costs of borrowing coupled with non-traded goods would explain the negative correlations found in the data.…”

“…G. Benigno and Thoenissen (2006) explain that costs of borrowing coupled with non-traded goods would explain the negative correlations found in the data. Similarly, Selaive and Tuesta (2003) argue that costs of borrowing and distribution costs for traded goods generate violations of the law of one price (intermediate degrees of pass-through), deviations from uncovered interest rate parity and sensible cross-correlations. Hence, current research seems to favor incomplete markets and borrowing costs as necessary devices to fit the key cross-correlations in the data.…”