Limited Participation and International Risk Sharing: Does the Nominal Exchange Rate Matter?

Abstract

In international business cycle models with complete financial markets, the consumption growth ratio moves in tandem with the real exchange rate growth. In the data, however, their correlation is often negative. International risk sharing is quite poor in reality. This consumption-real exchange rate anomaly, also called the Backus-Smith puzzle, is one of the major puzzles in international macroeconomics. Empirical results show that the nominal exchange rate movements are the main source for the Backus-Smith puzzle. This paper shows that an endogenous segmented asset markets model can solve the consumption-real exchange rate anomaly and reveal the role of the nominal exchange rate on international risk sharing. If the nominal exchange rate is fixed, international risk sharing improves in the simulated economy.