Working Paper

Incomplete Markets and Exchange Rates

Abstract: We show imperfect risk-sharing within countries can reconcile the aggregate cyclicality of exchange rates in a two-country setting, i.e. the Backus-Smith puzzle, as long as exchange rates are sufficiently risky with respect to idiosyncratic states. In equilibrium, these exchange rate dynamics require that, despite a country experiencing higher consumption growth, idiosyncratic risk remains relatively elevated. Furthermore, we identify distinct roles for market incompleteness both within and across countries, to match key moments of exchange rates. Turning to household-level data, we measure discount factor wedges which capture the effects of imperfect risk sharing, and we provide direct empirical support for the mechanism.

https://doi.org/10.24148/wp2025-11

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2025-07-08

Number: 2025-11