Working Paper: CEPR ID: DP8613
Authors: Giancarlo Corsetti; Luca Dedola; Francesca Viani
Abstract: Accounting for the pervasive evidence of limited international risk sharing is an important hurdle for open-economy models, especially when these are adopted in the analysis of policy trade-offs likely to be affected by imperfections in financial markets. Key to the literature is the evidence, at odds with efficiency, that consumption is relatively high in countries where its international relative price (the real exchange rate) is also high. We reconsider the relation between cross-country consumption differentials and real exchange rates, by decomposing it into two components, reflecting the prices of tradable and nontradable goods, respectively. We document that, as a common pattern among OECD countries, both components tend to contribute to the overall lack of risk sharing, with the tradable price component playing the dominant role in accounting for efficiency deviations. We relate these findings to two mechanisms proposed by the literature to reconcile open economy models with the data. One features strong Balassa-Samuelson effects on nontradable prices due to productivity gains in the tradable sector, with a muted offsetting response of tradable prices. The other, endogenous income effects causing nontradable but especially tradable prices to appreciate with a rise in domestic consumption demand.
Keywords: Consumption; Real exchange rate anomaly; Harrod-Balassa-Samuelson effect; Incomplete markets; International transmission mechanism; Terms of trade
JEL Codes: F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| domestic consumption increase (E20) | domestic relative price of nontradables increase (F49) |
| domestic consumption increase (E20) | domestic tradable prices appreciation (P22) |
| domestic consumption increase (E20) | negative correlation with real exchange rate (F31) |
| fall in international price of tradables (F16) | nontradable price component appreciation (F16) |