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International Asset Markets and Real Exchange Rate Volatility

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Author Info
Martin Bodenstein (Federal Reserve Board)

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Abstract

The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs better than a standard incomplete markets model with a single non-contingent bond unless very tight borrowing constraints are imposed in the latter. With limited enforcement for both domestic and international financial contracts, the model's asset pricing implications are brought into line with the empirical evidence, albeit at the expense of raising real exchange rate volatility. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2007.12.003
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Publisher Info
Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 11 (2008)
Issue (Month): 3 (July)
Pages: 688-705
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Handle: RePEc:red:issued:07-120

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Related research
Keywords: Risk-sharing Limited enforcement Real exchange rate Backus-Smith puzzle Asset prices

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Metodij Hadzi-Vaskov, 2008. "Does the Nominal Exchange Rate Explain the Backus-Smith Puzzle? Evidence from the Eurozone," Working Papers 07-32, Utrecht School of Economics. [Downloadable!]
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