Working Paper: CEPR ID: DP10724
Authors: Hande Kucuk; Alan Sutherland
Abstract: This paper aims to account for the Backus-Smith puzzle in a two-country DSGE model with endogenous portfolio choice in bonds and equities. Utility is non-separable across consumption and leisure and across time. This model is shown to imply almost zero correlation between relative consumption and the real exchange rate while generating portfolio positions that broadly match the data. Furthermore, the cross-country correlation of consumption is lower than the correlation of output, which has previously been a difficult fact to match. Non-separable preferences are found to be crucial to generating these results but financial market structure plays only a minor role.
Keywords: Backus-Smith puzzle; Consumption-Real exchange rate anomaly; Incomplete markets; International risk sharing; Nonseparable preferences; Portfolio choice
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nonseparable preferences (D10) | low correlation between relative consumption and the real exchange rate (F31) |
| nonseparable preferences across consumption and leisure (D10) | low correlation between relative consumption and the real exchange rate (F31) |
| nonseparable preferences across time (D15) | low correlation between relative consumption and the real exchange rate (F31) |
| habits in consumption + nonseparable preferences (D11) | reconciliation of observed patterns in portfolio positions with low correlation between consumption and the real exchange rate (F31) |