Working Paper: NBER ID: w18646
Authors: A. Craig Burnside; Jeremy J. Graveline
Abstract: If the asset market is complete then the difference between foreign and domestic agents' log intertemporal marginal rates of substitution (IMRSs) equals the log change in the real exchange rate. This equation is frequently used to argue that changes in real exchange rates reflect differences between agents' required compensation for exposure to asset return uncertainty. We show that the relative returns on frictionlessly traded assets are only reflected in the common component of agents' IMRSs, not differences. Instead, when this equation does offer insights, frictions in the goods market are the source of economic distinction between agents.
Keywords: exchange rates; asset market; risk sharing
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Complete asset market (G19) | log change in real exchange rate (F31) |
| log change in real exchange rate (F31) | difference in IMRS of foreign and domestic agents (L85) |
| Identical consumption aggregators + frictionless goods markets (D10) | constant real exchange rate (F31) |
| Real exchange rate variation (F31) | market frictions (D43) |
| Complete asset market + frictionless goods markets (G19) | equal IMRS of agents (L85) |
| Real exchange rate variation (F31) | differences in risk compensation (D11) |