Limited Stock Market Participation and Goods Market Frictions: A Potential Resolution for Puzzles in International Finance

Abstract

The popular assumption based on complete markets that the log of real exchange rate growth equals the difference between the logs of home and foreign IMRSs imposes a tight restriction on explaining the joint behavior of asset prices, exchange rates, and international risk sharing. We study asset prices, exchange rates, and consumption dynamics in a general equilibrium two-country macro-finance model that features both asset-market and goods-market frictions. For the asset-market friction, we consider limited stock market participation a la Guvenen (2009). In addition, we follow Corsetti, Dedola, and Leduc (2008) to model frictions to international trade such as non-traded goods and distribution cost. We provide analysis of the model linearized to the second order, by implementing the method proposed by Devereux and Sutherland (2010) to overcome the indeterminacy issues with portfolio choice. The model generates a high price of risk, smooth exchange rates, and makes substantial progress towards explaining the empirically observed low consumption growth correlation between countries. We find that distribution cost plays a central role for reducing international consumption co-movement while also amplifying risk premia.