International Asset Markets and Real Exchange Rate Volatility

RePEc Short ID: pbo319
ORCID iD: 0000-0002-4400-3719

Bodenstein, Martin

Working Paper

International Asset Markets and Real Exchange Rate Volatility

Abstract: The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs better than a standard incomplete markets model with a single non-contingent bond unless very tight borrowing constraints are imposed in the latter. With limited enforcement for both domestic and international financial contracts, the model's asset pricing implications are brought into line with the empirical evidence, albeit at the expense of raising real exchange rate volatility.

Keywords: Risk-sharing; Limited enforcement; Real exchange rate; Backus-Smith puzzle; Asset prices;

JEL Classification: F31; G12;