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Real exchange rate variability in a two country business cycle model

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  • Hakon Tretvoll

    (New York University)

Abstract

Real exchange rate fluctuations have important implications for our understanding of the sources and transmission of international business cycles, and the degree of international risk sharing. In most two-country business cycle models, the real exchange rate is determined by differences in consumption and leisure across countries, and its standard deviation is significantly smaller than we see in the data. With recursive preferences the marginal utility of consumption today also depends on innovations in agents' future utilities. Real exchange rate movements are therefore partially disconnected from current quantities. With permanent cointegrated technology shocks and home bias, the model generates realistic variability in the real exchange rate. The mechanism is similar to related work on asset pricing, and the model produces highly volatile stochastic discount factors with more realistic asset pricing implications. In addition, there is modest improvement in the cross-country correlations of quantities, as investment and employment are positively correlated across countries.

Suggested Citation

  • Hakon Tretvoll, 2012. "Real exchange rate variability in a two country business cycle model," 2012 Meeting Papers 911, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:911
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    References listed on IDEAS

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    Cited by:

    1. 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.
    2. Hakon Tretvoll, 2013. "Investment-Specific Technology Shocks and Recursive Preferences," 2013 Meeting Papers 1207, Society for Economic Dynamics.
    3. Michael Donadelli & Patrick Grüning & Aurelija Proskute, 2019. "Monetary policy, trade, and endogenous growth under different international financial market structures," Bank of Lithuania Working Paper Series 57, Bank of Lithuania.
    4. Grüning, Patrick, 2017. "International endogenous growth, macro anomalies, and asset prices," Journal of Economic Dynamics and Control, Elsevier, vol. 78(C), pages 118-148.
    5. Irina Zviadadze, 2017. "Term Structure of Consumption Risk Premia in the Cross Section of Currency Returns," Journal of Finance, American Finance Association, vol. 72(4), pages 1529-1566, August.
    6. Ric Colacito & Max Croce & Steven Ho & Philip Howard, 2018. "BKK the EZ Way: International Long-Run Growth News and Capital Flows," American Economic Review, American Economic Association, vol. 108(11), pages 3416-3449, November.
    7. Backus, David & Coleman, Chase & Ferriere, Axelle & Lyon, Spencer, 2016. "Pareto weights as wedges in two-country models," Journal of Economic Dynamics and Control, Elsevier, vol. 72(C), pages 98-110.
    8. Caporale, Guglielmo Maria & Donadelli, Michael & Varani, Alessia, 2015. "International capital markets structure, preferences and puzzles: A “US–China World”," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 36(C), pages 85-99.

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