nep-dge New Economics Papers
on Dynamic General Equilibrium
Issue of 2011‒08‒22
24 papers chosen by
Christian Zimmermann
Federal Reserve Bank of St. Louis

  1. Pro-cyclical Unemployment Benefits? Optimal Policy in an Equilibrium Business Cycle Model By Kurt Mitman; Stanislav Rabinovich
  2. A General Equilibrium Model of Sovereign Default and Business Cycles By Vivian Z. Yue; Enrique G. Mendoza
  3. The Extensive Margin, Sectoral Shares and International Business Cycles By Michael B. Devereux; Viktoria Hnatkovska
  4. Fiscal Federalism, Public Capital Formation, and Endogenous Growth By Liutang Gong; Heng-fu Zou
  5. Income Inequality, Mobility, and the Welfare State: A Political Economy Model By Bossi, Luca; Gumus, Gulcin
  6. Fiscal Volatility Shocks and Economic Activity By Jesus Fernandez-Villaverde; Pablo Guerron-Quintana; Keith Kuester; Juan Rubio-Ramirez
  7. A quantitative analysis of the U.S. housing and mortgage markets and the foreclosure crisis By Satyajit Chatterjee; Burcu Eyigungor
  8. Health, Taxes, and Growth By Liutang Gong; Hongyi Li; Dihai Wang; Heng-fu Zou
  9. Equilibrium Wage and Employment Dynamics in a Model of Wage Posting without Commitment By Coles, Melvyn; Mortensen, Dale T.
  10. Business Cycle and Bank Capital Regulation: Basel II Procyclicality By Guangling (Dave) Liu; Nkhahle E. Seeiso
  11. Policy Change and Learning in the RBC Model By Kaushik Mitra; George W. Evans; Seppo Honkapohja
  12. Money, interest rates and the real activity By Hong, Hao
  13. Optimal taxes on fossil fuel in general equilibrium By Golosov, Mikhail; Hassler, John; Krusell, Per; Tsyvinski, Aleh
  14. "Social Security: Universal vs. Earnings-Dependent Benefits" By Jorge Soares
  15. The Dynamic Implications of Debt Relief for Low-Income Countries By Alma Romero-Barrutieta; Jose Daniel Rodríguez-Delgado; Ales Bulir
  16. Individual and Aggregate Money Demands By André C. Silva
  17. Additive habits with power utility: Estimates, asymptotics and equilibrium By Roman Muraviev
  18. Optimal monetary policy in a model of money and credit By Pedro Gomis-Porqueras; Daniel R. Sanches
  19. Structural Transformation and Productivity in Latin America By Silva, Leonardo Fonseca da; Ferreira, Pedro Cavalcanti
  20. Internal Rationality, Imperfect Market Knowledge and Asset Prices By Klaus Adam; Albert Marcet
  21. Simultaneous Search and Network Efficiency By Gautier, Pieter A; Holzner, Christian
  22. House Price Booms and the Current Account By Klaus Adam; Pei Kuang; Albert Marcet
  23. A Gains from Trade Perspective on Macroeconomic Fluctuations By Paul Beaudry; Franck Portier
  24. Consumption Risk-Sharing and the Real Exchange Rate: Why does the Nominal Exchange Rate Make Such a Difference? By Michael B. Devereux; Viktoria Hnatkovska

  1. By: Kurt Mitman (Department of Economics, University of Pennsylvania); Stanislav Rabinovich (Department of Economics, University of Pennsylvania)
    Abstract: We study the optimal provision of unemployment insurance (UI) over the business cycle. We use an equilibrium search and matching model with aggregate shocks to labor productivity, incorporating risk-averse workers, endogenous worker search effort decisions, and unemployment benefit expiration. We characterize the optimal UI policy, allowing both the benefit level and benefit duration to depend on the history of past aggregate shocks. We find that the optimal benefit is decreasing in current productivity and decreasing in current unemployment. Following a drop in productivity, benefits initially rise in order to provide short-run relief to the unemployed and stabilize wages, but then fall significantly below their pre-recession level, in order to speed up the subsequent recovery. Under the optimal policy, the path of benefits is pro-cyclical overall. As compared to the existing US UI system, the optimal history-dependent benefits smooth cyclical fluctuations in unemployment and deliver substantial welfare gains.
    Keywords: Unemployment Insurance, Business Cycles, Optimal Policy, Search and Matching
    JEL: E24 E32 H21 J65
    Date: 2011–08–07
  2. By: Vivian Z. Yue; Enrique G. Mendoza
    Abstract: Emerging markets business cycle models treat default risk as part of an exogenous interest rate on working capital, while sovereign default models treat income fluctuations as an exogenous endowment process with ad-noc default costs. We propose instead a general equilibrium model of both sovereign default and business cycles. In the model, some imported inputs require working capital financing; default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around default triggers an efficiency loss as these inputs are replaced by imperfect substitutes; and default on public and private obligations occurs simultaneously. The model explains several features of cyclical dynamics around deraults, countercyclical spreads, high debt ratios, and key business cycle moments.
    Keywords: Sovereign debt , Business cycles , Economic models , External debt , Emerging markets , Credit risk ,
    Date: 2011–07–14
  3. By: Michael B. Devereux; Viktoria Hnatkovska
    Abstract: This paper documents some previously neglected features of sectoral shares at business cycle frequencies in OECD economies. In particular, we find that the nontraded sector share of output is as volatile as aggregate GDP, and that for most countries, the nontraded sector is distinctly countercyclical. While the standard international real business cycle model has difficulty in accounting for these properties of the data, an extended model which allows for sectoral adjustment along both the intensive and extensive margins does a much better job in replicating the volatilities and co-movements in the data. In addition, the model provides a closer match between theory and data with respect to the correlation between relative consumption growth and real exchange rate changes, a key measure of international risk-sharing.
    JEL: F3 F4
    Date: 2011–08
  4. By: Liutang Gong (Guanghua School of Management, Peking University; Institute for Advanced Study, Wuhan University); Heng-fu Zou (Guanghua School of Management, Peking University; Institute for Advanced Study, Wuhan University; Development Research Group, The World Bank)
    Abstract: This paper extends the Barro (1990) growth model with one aggregate government spending and one flat income tax to include federal and local public consumption, federal and local public capital formation, federal and local taxes, and federal transfers to locality. It derives the rate of endogenous growth and examines how the growth rate and welfare respond to changes in federal taxes, local taxes, and federal transfers.
    Keywords: Fiscal federalism, Public expenditures, Public capital, Taxes, Federal transfers, Endogenous growth
    JEL: E0 G1 H0 O0
    Date: 2011
  5. By: Bossi, Luca (University of Pennsylvania); Gumus, Gulcin (Florida Atlantic University)
    Abstract: In this paper, we set up a three-period stochastic overlapping generations model to analyze the implications of income inequality and mobility for demand for redistribution and social insurance. We model the size of two different public programs under the welfare state. We investigate bidimensional voting on the tax rates that determine the allocation of government revenues among transfer payments and old-age pensions. We show that the coalitions formed, the resulting political equilibria, and the demand for redistribution crucially depend on the level of income inequality and mobility.
    Keywords: redistribution, mobility, inequality, structure induced equilibrium
    JEL: D72 H53 H55
    Date: 2011–08
  6. By: Jesus Fernandez-Villaverde (Department of Economics, University of Pennsylvania); Pablo Guerron-Quintana (Federal Reserve Bank of Philadelphia); Keith Kuester (Federal Reserve Bank of Philadelphia); Juan Rubio-Ramirez (Department of Economics, Duke University)
    Abstract: We study the effects of changes in uncertainty about future fiscal policy on aggregate economic activity. Fiscal deficits and public debt have risen sharply in the wake of the financial crisis. While these developments make fisscal consolidation inevitable, there is considerable uncertainty about the policy mix and timing of such budgetary adjustment. To evaluate the consequences of this increased uncertainty, we first estimate tax and spending processes for the U.S. that allow for time-varying volatility. We then feed these processes into an otherwise standard New Keynesian business cycle model calibrated to the U.S. economy. We find that fiscal volatility shocks have an adverse effect on economic activity that is comparable to the effects of a 25-basis-point innovation in the federal funds rate.
    Keywords: DSGE models, Uncertainty, Fiscal Policy, Monetary Policy
    JEL: E10 E30 C11
    Date: 2011–08–09
  7. By: Satyajit Chatterjee; Burcu Eyigungor
    Abstract: The authors construct a quantitative equilibrium model of the housing sector that accounts for the homeownership rate, the average foreclosure rate, and the distribution of home-equity ratios across homeowners prior to the recent boom and bust in the housing market. They analyze the key mechanisms that account for these facts, including the preferential tax treatment of housing and in ation. The authors then use the model to gain a deeper understanding of the recent housing and mortgage crisis by studying the consequence of an unanticipated increase in the supply of housing (overbuilding shock). They show that the model can account for the observed decline in house prices and much of the increase in the foreclosure rate if two additional forces are taken into account: (i) the lengthening of the time to complete a foreclosure (during which a defaulter can stay rent-free in his house) and (ii) the tightening of credit constraints in the market for new mortgages.
    Keywords: Foreclosure ; Global financial crisis ; Mortgage loans
    Date: 2011
  8. By: Liutang Gong (Guanghua School of Management, Peking University); Hongyi Li (BA Faculty, Chinese University of Hong Kong); Dihai Wang (School of Economics, Fudan University); Heng-fu Zou (CEMA, Central University, China; School of Advanced Study (SAS), Shenzhen University, China; IAS, Wuhan University, China; Guanghua School of Management, Peking University, China)
    Abstract: This paper studies capital accumulation and consumption in the traditional Ramsey model under an exogenous growth framework. The model has three important features: (1) treating health as a simple function of consumption, which enable the study of health and growth in an aggregate macroeconomic model; (2) the existence of multiple equilibria of capital stock, health, and consumption, which is more consistent with the real world situation-rich countries may end up with high capital, better health, and higher consumption than poor countries; (3) the fundamental proposition of a consumption tax instead of capital taxation from the traditional growth model does not hold anymore in our model. As long as consumption goods contribute to health formation, the issue of a consumption tax versus an income (or capital) tax should be re-examined.
    Keywords: Health, Capital accumulation, Taxation
    JEL: H0 I1 O3 O4
    Date: 2011
  9. By: Coles, Melvyn (University of Essex); Mortensen, Dale T. (Northwestern University)
    Abstract: A rich but tractable variant of the Burdett-Mortensen model of wage setting behavior is formulated and a dynamic market equilibrium solution to the model is defined and characterized. In the model, firms cannot commit to wage contracts. Instead, the Markov perfect equilibrium to the wage setting game, characterized by Coles (2001), is assumed. In addition, firm recruiting decisions, firm entry and exit, and transitory firm productivity shocks are incorporated into the model. Given that the cost of recruiting workers is proportional to firm employment, we establish the existence of an equilibrium solution to the model in which wages are not contingent on firm size but more productive employers always pay higher wages. Although the state space, the distribution of workers over firms, is large in the general case, it reduces to a scalar that can be interpreted as the unemployment rate in the special case of homogenous firms. Furthermore, the equilibrium is unique. As the dimension of the state space is equal to the number of firms types in general, an (approximate) equilibrium is computable.
    Keywords: wage dispersion, wage setting, rank-preserving equilibrium
    JEL: D21 D49 E23 J42 J64
    Date: 2011–08
  10. By: Guangling (Dave) Liu; Nkhahle E. Seeiso
    Abstract: This paper studies the impacts of bank capital regulation on business cycle fluctuations. To do so, we adopt the Bernanke et al. (1999) "financial accelerator" model (BGG), to which we augment a banking sector to study the procyclical nature of Basel II claimed in the literature. We first study the impacts of a negative shock to entrepreneur's net worth and a positive monetary policy shock on business cycle fluctuations. We then look at the impacts of a negative shock to the entrepreneurs' net worth when the minimum capital requirement increases from 8 percent to 12 percent. Our comparison studies between the augmented BGG model with Basel I bank regulation and the one with Basel II bank regulation suggest that, in the presence of credit market frictions and bank capital regulation, the liquidity premium effect further ampliflies the financial accelerator effect through the external finance premium channel, which in turn, contributes to the amplification of Basel II procyclicality. Moreover, under Basel II bank regulation, in response to a negative net worth shock, the liquidity premium and the external finance premium rise much more if the minimum bank capital requirement increases, which in turn, amplify the response of real variables. Finally, small adjustments in monetary policy can result in stronger response in the real economy, in the presence of Basel II bank regulation in particular, which is undesirable.
    Keywords: Business cycle fluctuations, Financial accelerator, Bank capital requirement, Monetary policy
    JEL: E32 E44 G28 E50
    Date: 2011
  11. By: Kaushik Mitra; George W. Evans; Seppo Honkapohja
    Abstract: What is the impact of surprise and anticipated policy changes when agents form expectations using adaptive learning rather than rational expectations? We examine this issue using the standard stochastic real business cycle model with lump-sum taxes. Agents combine knowledge about future policy with econometric forecasts of future wages and interest rates. Both permanent and temporary policy changes are analyzed. Dynamics under learning can have large impact effects and a gradual hump-shaped response, and tend to be prominently characterized by oscillations not present under rational expectations. These fluctuations reflect periods of excessive optimism or pessimism, followed by subsequent corrections.
    Keywords: Taxation, Government Spending, Expectations, Permanent and temporary policy changes.
    JEL: E62 D84 E21 E43
    Date: 2011–08–11
  12. By: Hong, Hao (Cardiff Business School)
    Abstract: This paper examines the effectiveness of monetary aggregates through various nominal interest rates by integrating the financial sector into the Cash-in-Advance (CIA) economy. The model assumes that there are two types of representative agents in the financial sector, which are: productive banks and financial intermediates. The productive banks supply a financial service, which is an exchange technology service to households and financial intermediates receive savings fund from savers and offer loans to borrowers. The monetary expansions are increased banking costs through the rate of inflation. It leads households to use more exchange credit relative to cash at the goods market. Since the number of savings funds is equal to the number of exchange credits used at the goods market, money injections are lower the nominal interest rate on saving as the saving fund increases with exchange credit. By assuming that firms are the only borrowers at the capital market from Fuerst (1992), a lower nominal interest rate on the saving fund reduces the marginal cost of labour and increases labour demand. Meanwhile, the increasing marginal cost of money through the expected inflation effect has a negative effect on labour supply. With labour demand dominating labour supply effects, both output and employment increase with monetary expansion. The paper is able to generate a decreasing nominal interest rate with an increasing money supply with an absence of limited participation monetary shocks from Lucas (1990); and by allowing firms to borrow wage bills payment from financial intermediates, it examines the positive response of aggregate output subject to monetary expansion under flexible price framework.
    Keywords: monetary transmission; business cycles; banking sector; interest rates
    JEL: E10 E44 E51
    Date: 2011–07
  13. By: Golosov, Mikhail; Hassler, John; Krusell, Per; Tsyvinski, Aleh
    Abstract: We analyze a dynamic stochastic general-equilibrium (DSGE) model with an externality---through climate change---from using fossil energy. A central result of our paper is an analytical derivation of a simple formula for the marginal externality damage of emissions. This formula, which holds under quite plausible assumptions, reveals that the damage is proportional to current GDP, with the proportion depending only on three factors: (i) discounting, (ii) the expected damage elasticity (how many percent of the output flow is lost from an extra unit of carbon in the atmosphere), and (iii) the structure of carbon depreciation in the atmosphere. Very importantly, future values of output, consumption, and the atmospheric CO2 concentration, as well as the paths of technology and population, and so on, all disappear from the formula. The optimal tax, using a standard Pigou argument, is then equal to this marginal externality. The simplicity of the formula allows the optimal tax to be easily parameterized and computed. Based on parameter estimates that rely on updated natural-science studies, we find that the optimal tax should be a bit higher than the median, or most well-known, estimates in the literature. We also show how the optimal taxes depend on the expectations and the possible resolution of the uncertainty regarding future damages. Finally, we compute the optimal and market paths for the use of energy and the corresponding climate change.
    Keywords: climate externality; integrated assessment model; optimal carbon taxes
    JEL: E0 Q5
    Date: 2011–08
  14. By: Jorge Soares (Department of Economics,University of Delaware)
    Abstract: I compare the welfare implications of implementing Bismarckian and Beveridgean social security systems. In an overlapping generations environment with intragenerational homogeneity, agents can be better off with a system with universal benefits than with a comparable system with earnings-dependent benefits because the latter generates a stronger decrease in net wages. Once I allow for intragenerational skill heterogeneity, agents are on average better off with the more redistributive universal benefits system. I then let agents vote for the replacement rates in a democratic process. In the absence of intragenerational heterogeneity, a larger social security system is implemented when benefits are earnings-dependent than when they are universal resulting in a larger decrease in net wages; this makes young agents worse o¤ with earnings-dependent benefits. In the presence of intragenerational skill heterogeneity, the reverse occurs and agents fare on average better in the long-run when benefits are earnings-dependent. However, because of its redistributional effects, agents born at the time of implementation are on average better o¤ with an universal benefits system.
    Keywords: social security, universal benefits, earnings-dependent benefits, Bismarckian social security system, Beveridgean social security system, voting, welfare.
    JEL: E62 H55
    Date: 2011
  15. By: Alma Romero-Barrutieta; Jose Daniel Rodríguez-Delgado; Ales Bulir
    Abstract: The effects of debt relief on incentives to accumulate debt, consume, and invest are an important concern for donors and recipients. Using a dynamic stochastic general equilibrium model of a small open economy with a minimum consumption requirement and an endogenous relief probability, we show that excessive debt accumulation is consistent with an anticipation of a future debt relief. Simulations of the calibrated model using 1982-2006 Ugandan data suggest that debt-relief episodes are likely to have only a temporary impact on the level of debt in low-income countries, while being associated with more consumption and less invesment. The long-run debt-to-GDP ratio is estimated to be about twice as high with debt relief than without it.
    Keywords: Debt problems , Debt relief , Economic models , External debt , Heavily indebted poor countries , HIPC Initiative , Low-income developing countries ,
    Date: 2011–07–06
  16. By: André C. Silva
    Abstract: I construct a model in which money and bond holdings are consistent with individual decisions and aggregate variables such as production and interest rates. The agents are infinitely-lived, have constant-elasticity preferences, and receive a fraction of their income in money. Each agent solves a Baumol-Tobin money management problem. Markets are segmented because financial frictions make agents trade bonds for money at different times. Trading frequency, consumption, government decisions and prices are mutually consistent. An increase in inflation, for example, implies higher trading frequency, more bonds sold to account for seigniorage, and lower real balances. JEL codes:E3, E4, E5
    Keywords: money demand, cash management, inventory problem, market segmentation
    Date: 2011
  17. By: Roman Muraviev
    Abstract: We consider a power utility maximization problem with additive habits in a framework of discrete-time markets and random endowments. For certain classes of incomplete markets, we establish estimates for the optimal consumption stream in terms of the aggregate state price density, investigate the asymptotic behaviour of the propensity to consume (ratio of the consumption to the wealth), as the initial endowment tends to infinity, and show that the limit is the corresponding quantity in an artificial market. For complete markets, we concentrate on proving the existence of an Arrow-Debreu equilibrium in an economy inhabited by heterogeneous individuals who differ with respect to their risk-aversion coefficient, impatience rate and endowments stream, but possess the same degree of habit-formation. Finally, in a representative agent equilibrium, we compute explicitly the price of a zero coupon bond and the Lucas tree equity, and study its dependence on the habit-formation parameter.
    Date: 2011–08
  18. By: Pedro Gomis-Porqueras; Daniel R. Sanches
    Abstract: The authors investigate the extent to which monetary policy can enhance the functioning of the private credit system. Specifically, they characterize the optimal return on money in the presence of credit arrangements. There is a dual role for credit: It allows buyers to trade without fiat money and also permits them to borrow against future income. However, not all traders have access to credit. As a result, there is a social role for fiat money because it allows agents to self-insure against the risk of not being able to use credit in some transactions. The authors consider a (nonlinear) monetary mechanism that is designed to enhance the credit system. An active monetary policy is sufficient for relaxing credit constraints. Finally, they characterize the optimal monetary policy and show that it necessarily entails a positive inflation rate, which is required to induce cooperation in the credit system.
    Keywords: Monetary policy ; Money ; Credit
    Date: 2011
  19. By: Silva, Leonardo Fonseca da; Ferreira, Pedro Cavalcanti
    Abstract: We investigate the role of sectorial differences in labor productivity and the process of structural transformation (reallocation of labor across sectors) in accounting for the time path of aggregate productivity across six Latin American countries (Brazil, Chile, Argentina, Colombia, Mexico and Venezuela) from 1950 to 2003. We used a general equilibrium model with three sectors (agriculture, industry and services) calibrated to those six economies. The model is used to compare the trajectory of productivity in each sector of activity with that of the United States and it impact on aggregate productivity.While in Brazil and Argentina, the Service Sector was responsible for reversing the process of catch up in productivity that occurred until the 1980s, in others, like Colombia, Mexico and Venezuela, low productivity growth of the three sectors explain their poor performance.
    Date: 2011–08–12
  20. By: Klaus Adam; Albert Marcet
    Abstract: We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be 'externally rational', i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors' expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents' market knowledge.
    Keywords: learning, internal rationality, consumption based asset pricing
    JEL: G12 G14 D83 D84
    Date: 2011–08
  21. By: Gautier, Pieter A; Holzner, Christian
    Abstract: When workers send applications to vacancies they create a network. Frictions arise if workers do not know where other workers apply to (this affects network creation) and firms do not know which candidates other firms consider (this affects network clearing). We show that those frictions and the wage mechanism are in general not independent. Equilibria that exhibit wage dispersion are inefficient in terms of network formation. Under complete recall (firms can go back and forth between all their candidates) only wage mechanisms that allow for ex post Bertrand competition generate the maximum matching on a realized network.
    Keywords: Efficiency; network clearing; random bipartite network formation; simultaneous search
    JEL: D83 D85 E24 J64
    Date: 2011–08
  22. By: Klaus Adam; Pei Kuang; Albert Marcet
    Abstract: A simple open economy asset pricing model can account for the house price and current account dynamics in the G7 over the years 2001-2008. The model features rational households, but assumes that households entertain subjective beliefs about price behavior and update these using Bayes' rule. The resulting beliefs dynamics considerably propagate economic shocks and crucially contribute to replicating the empirical evidence. Belief dynamics can temporarily delink house prices from fundamentals, so that low interest rates can fuel a house price boom. House price booms, however, are not necessarily synchronized across countries and the model correctly predicts the heterogeneous response of house prices across the G7, following the fall in real interest rates at the beginning of the millennium. The response to interest rates depends sensitively on agents' beliefs at the time of the interest rate reduction, which are a function of the prior history of disturbances hitting the economy. According to the model, the US house price boom could have been largely avoided, if real interest rates had decreased by less after the year 2000.
    Keywords: interest rates, house prices, short-term capital movements
    JEL: F41 F32 E43
    Date: 2011–07
  23. By: Paul Beaudry; Franck Portier
    Abstract: Business cycles reflect changes over time in the amount of trade between individuals. In this paper we show that incorporating explicitly intra-temporal gains from trade between individuals into a macroeconomic model can provide new insight into the potential mechanisms driving economic fluctuations as well as modify key policy implications. We first show how a "gains from trade" approach can easily explain why changes in perceptions about the future (including "news" about the future) can cause booms and bust. We then turn to fiscal policy, and discuss under what conditions fiscal multipliers can be observed. While much of our analysis is conducted in a flexible price environment, we also present implications of our model for a sticky price environments, as it allows to understand stable-inflation boom-bust cycles. The source of the explicit gains from trade in our setup derives from simply assuming that in the short run workers are not perfect mobile across all sectors of the economy. We provide evidence from the PSID in support of this modeling assumption.
    JEL: E32
    Date: 2011–08
  24. By: Michael B. Devereux; Viktoria Hnatkovska
    Abstract: A basic prediction of effcient risk-sharing is that relative consumption growth rates across countries or regions should be positively related to real exchange rate growth rates across the same areas. We investigate this hypothesis, employing a newly constructed multi-country and multi-regional data set. Within countries, we find signifcant evidence for risk sharing: episodes of high relative regional consumption growth are associated with regional real exchange rate depreciation. Across countries however, the association is reversed: relative consumption and real exchange rates are negatively correlated. We identify this failure of risk sharing as a border effect. We find that the border effect is substantially (but not fully) accounted for by nominal exchange rate variability. We then ask whether standard open economy macro models can explain these features of the data. We argue that they cannot. To explain the role of the nominal exchange rate in deviations from cross country consumption risk sharing, it is necessary to combine multiple sources of shocks, ex-ante price setting, and incomplete financial markets.
    JEL: F3 F4
    Date: 2011–08

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