Working Paper: CEPR ID: DP17596
Authors: Karen K. Lewis; Edith X. Liu
Abstract: When available financial securities allow investors to optimally diversify risk across countries, standard theory implies that exchange rates should reflect this behavior. However, exchange rates observed in the data deviate from these predictions. In this paper, we develop a framework to value the welfare costs of these exchange rate wedges, as disciplined by asset returns. This framework applies to a general class of asset pricing and exchange rate models. We further decompose the value of these wedges into components, showing that the ability of goods markets to respond to financial markets through exchange rate adjustment has significant implications for welfare.
Keywords: international spillovers; incomplete and complete markets
JEL Codes: F30; F31; F41; G10; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asset prices (G19) | welfare costs of exchange rate wedges (F16) |
| exchange rate wedges (F31) | inefficiencies in financial markets (G19) |
| marginal utilities of consumption equalize (D11) | direct measurement of welfare differentials (D69) |
| incomplete financial markets (D52) | welfare differences quantified through asset pricing data (D69) |
| goods markets respond to financial markets (G10) | welfare implications (I30) |
| stochastic discount factors (D15) | valuations of asset returns (G12) |