DP6192 Household Heterogeneity and Real Exchange Rates

Author(s): Narayana Kocherlakota, Luigi Pistaferri
Publication Date: March 2007
Keyword(s): market incompleteness, Pareto optimality, precautionary savings, real exchange rate
JEL(s): D63, E21, F31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6192

We assume that individuals can fully insure themselves against cross-country shocks, but not against individual-specific shocks. We consider two particular models of limited risk-sharing: domestically incomplete markets (DI) and private information-Pareto optimal (PIPO) risk-sharing. For each model, we derive a restriction relating the cross-sectional distributions of consumption and real exchange rates. We evaluate these restrictions using household-level consumption data from the US and the UK. We show that the PIPO restriction fits the data well when households have a coefficient of relative risk aversion of around 5. The restrictions implied by the complete risk-sharing model and the DI model fare poorly.