Working Paper: CEPR ID: DP10232
Authors: Robert Kollmann
Abstract: Standard macro models cannot explain why real exchange rates are volatile and disconnected from macro aggregates. Recent research argues that models with persistent growth rate shocks and recursive preferences can solve that puzzle. I show that this result is highly sensitive to the structure of financial markets. When just a bond can be traded internationally, then long-run risk generates insufficient exchange rate volatility. A longrun risk model with recursive-preferences in which all agents trade in complete global financial markets can generate realistic exchange rate volatility; however, I show that this entails huge international wealth transfers, and excessive swings in net foreign asset positions. By contrast, a long-run risk, recursive-preferences model in which only a small fraction of households trades in complete markets, while the remaining households lead hand-to-mouth lives, generates realistic exchange rate and external balance volatility
Keywords: exchange rate; long-run risk; recursive preferences; complete financial markets; financial frictions; international risk sharing
JEL Codes: F31; F36; F41; F43; F44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Long-run risk, Recursive preferences (D15) | Exchange rate volatility (F31) |
| Incomplete financial markets (D52) | Exchange rate dynamics (F31) |
| Incomplete financial markets (D52) | Net foreign assets (F21) |
| Household heterogeneity (D19) | Exchange rate volatility (F31) |
| Household heterogeneity (D19) | Net foreign assets (F21) |