Currency Risk and Capital Accumulation

Abstract

The Lucas Paradox states that there are large and persistent differences in capital-output ratios across countries, suggesting capital is not flowing to countries where it is relatively scarce. In the data, capital-output ratios vary a lot cross-sectionally even within developed countries, and they are negatively correlated with currency risk premia and risk-free rates. To rationalize these patterns, I build a quantitative multi-country model of capital accumulation with external habit and heterogeneous exposures to a global productivity shock. I show that currency risk in this model generates cross-country variations in risk-free rates and capital-output ratios that are consistent with the data. I estimate the model using GDP data from countries issuing the G10 currencies and find two main results: (1) The heterogenous loadings that I extract from GDP data alone are highly correlated with capital-output ratios; and (2) when I feed the estimated loadings to the model, model-generated capital-output ratios account for roughly 55% of the cross-country variation in the data. I conclude that variation in currency risk and therefore currency risk premia have significant effects on the real economy.