Working Paper: NBER ID: w30422
Authors: Karen K. Lewis; Edith 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: No keywords provided
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) | Valuation of differences between observed real exchange rates and those predicted by optimally diversified financial markets (F31) |
| Exchange rate misalignments (F31) | Welfare costs (D69) |
| Differences in stochastic discount factors (D15) | Welfare differentials (I38) |
| Wedges (deviations from complete markets) (D52) | Welfare implications (D69) |
| Correlation of consumption growth across countries (F62) | Value of wedges (D46) |
| Stochastic discount factors (D15) | Value of wealth under complete markets relative to data measures (G19) |
| Exchange rate wedges (F31) | Inefficiencies in risk-sharing across countries (F65) |