DP7452 Limited Asset Market Participation and the Consumption-Real Exchange Rate Anomaly

Author(s): Robert Kollmann
Publication Date: September 2009
Keyword(s): consumption, hand to mouth consumers, limited asset market participation, real exchange rate
JEL(s): F36, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7452

Under efficient consumption risk sharing, as assumed in standard international business cycle models, a country?s aggregate consumption rises relative to foreign consumption, when the country?s real exchange rate depreciates. Yet, empirically, relative consumption and the real exchange rate are essentially uncorrelated. I show that this ?consumption-real exchange rate anomaly? can be explained by a simple model in which a subset of households trade in complete financial markets, while the remaining households lead hand-to-mouth (HTM) lives. HTM behavior also generates greater volatility of the real exchange rate and of net exports, which likewise brings the model closer to the data.