The Federal Reserve Board eagle logo links to Board's home page

International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page International Asset Markets And Real Exchange Rate Volatility
Martin Bodenstein
2006-884  (November 2006, latest version July 2008)

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.

Full paper, latest version (252 KB PDF) | Full paper (screen reader version)
Original version (336 KB PDF)

Risk-sharing, limited enforcement, real exchange rate, Backus-Smith puzzle, asset prices

PDF files: Adobe Acrobat Reader   ZIP files: PKWARE

Home | IFDPs | List of 2006 IFDPs
Accessibility | Contact Us
Last update: August 18, 2008