Working Paper: CEPR ID: DP10940
Authors: Robert Kollmann
Abstract: This paper analyzes the effects of output volatility shocks and of risk appetite shocks on the dynamics of consumption, trade flows and the real exchange rate, in a two-country world with recursive preferences and complete financial markets. When the risk aversion coefficient exceeds the inverse of the intertemporal substitution elasticity, then an exogenous rise in a country?s output volatility triggers a wealth transfer to that country, in equilibrium; this raises its consumption, lowers its trade balance and appreciates its real exchange rate. The effects of risk appetite shocks resemble those of volatility shocks. In a recursive preferences-complete markets framework, volatility and risk appetite shocks account for a noticeable share of the fluctuations of net exports, net foreign assets and the real exchange rate. These shocks help to explain the high empirical volatility of the real exchange rate and the disconnect between relative consumption growth and the real exchange rate.
Keywords: Consumption; Real exchange rate anomaly; Exchange rate; External balance; Risk appetite; Volatility shock
JEL Codes: F31; F32; F36; F41; F43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exogenous increase in a country's output volatility (F41) | wealth transfer to that country (H87) |
| wealth transfer to that country (H87) | increased consumption (E21) |
| wealth transfer to that country (H87) | lower trade balance (F19) |
| wealth transfer to that country (H87) | appreciation of its real exchange rate (F31) |
| risk appetite shocks (D81) | increased consumption (E21) |
| risk appetite shocks (D81) | appreciation of its real exchange rate (F31) |