Domestic Financial Frictions: Implications for International Risk Sharing, Real Exchange Rate Volatility and International Business Cycles

Under complete international financial markets, as assumed in standard international business cycle models, a country’s aggregate consumption rises relative to foreign consumption, in states of the world in which the country’s real exchange rate depreciates. Empirically, relative consumption spending and the real exchange rate are essentially uncorrelated. I show that this consumption-real exchange rate anomaly’ can be explained by a model in which only a fraction of households trade in complete financial markets, while the remaining households do not participate in financial markets, and thus act in a hand-to-mouth (HTM) manner. HTM behavior also generates a more volatile real exchange rate, which also brings the model closer to the data.