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International Capital Markets Structure, Preferences and Puzzles: The US-China Case

Author

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  • Guglielmo Maria Caporale
  • Michael Donadelli
  • Alessia Varani

Abstract

A canonical two country-two good model with standard preferences does not address three classic international macroeconomic puzzles as well as two well-known asset pricing puzzles. Specifically, under financial autarky, it does not account for the high real exchange rate (RER) volatility relative to consumption volatility (RER volatility puzzle), the negative RER-consumption differentials correlation (Backus-Smith anomaly), the relatively low cross- country consumption correlation (consumption correlation puzzle), the low risk-free rate (risk-free rate puzzle) and the high equity risk premium (equity premium puzzle) in the data. In this paper, we show that instead a two country-two good model with recursive preferences, international complete markets and correlated long-run innovations can address all five puzzles for a relatively large range of parameter values, specifically in the case of the US and China. Therefore, in contrast to other IBC models, its performance does not rely on any financial market imperfections.

Suggested Citation

  • Guglielmo Maria Caporale & Michael Donadelli & Alessia Varani, 2014. "International Capital Markets Structure, Preferences and Puzzles: The US-China Case," Discussion Papers of DIW Berlin 1362, DIW Berlin, German Institute for Economic Research.
    • Handle: RePEc:diw:diwwpp:dp1362
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    References listed on IDEAS

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    Cited by:

    1. Robert Kollmann, 2015. "Risk Sharing in a World Economy with Uncertainty Shocks," Working Papers ECARES ECARES 2015-43, ULB -- Universite Libre de Bruxelles.
    2. Robert Kollmann, 2015. "Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences," Open Economies Review, Springer, vol. 26(2), pages 175-196, April.
    3. Robert Kollmann, 2019. "Explaining International Business Cycle Synchronization: Recursive Preferences and the Terms of Trade Channel," Open Economies Review, Springer, vol. 30(1), pages 65-85, February.
    4. Robert Kollmann, 2015. "Exchange Rate and Current Account Dynamics: the Role of Asset Market Structure, Long-Run Risk and Risk Appetite," 2015 Meeting Papers 1397, Society for Economic Dynamics.
    5. Kollmann, Robert, 2016. "International business cycles and risk sharing with uncertainty shocks and recursive preferences," Journal of Economic Dynamics and Control, Elsevier, vol. 72(C), pages 115-124.
    6. Robert Kollmann, 2016. "Risk Sharing, the Exchange Rate and Net Foreign Assets in a World Economy with Uncertainty Shocks," 2016 Meeting Papers 721, Society for Economic Dynamics.
    7. Robert Kollmann, 2017. "Explaining International Business Cycle Synchronization," 2017 Meeting Papers 1489, Society for Economic Dynamics.

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    More about this item

    Keywords

    Financial autarky; complete markets; long-run risk; anomalies;
    All these keywords.

    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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