Consumption of Traded Goods and Real Exchange Rate Dynamics with Epstein-Zin Preferences

Abstract

The paper analyzes the consumption-real exchange rate anomaly in a multi-country model with complete markets under various preference specifications: (i) standard time-additive preferences; (ii) recursive preferences of Epstein and Zin; and (iii) habit formation preferences of Campbell and Cochrane. Recent research indicates that non-standard preferences can successfully replicate the low correlation between consumption and real exchange rates as in the data, thus resolving the anomaly. Optimal consumption risk sharing requires a reallocation of traded goods across countries. I show that such an optimal reallocation in this class of models links bilateral real exchange rate dynamics to consumption in both countries and to the ratio of domestic consumption of home endowment relative to exports of domestic goods to the foreign country. This implication finds little empirical support with data for 9 OECD economies.