Origins of International Factor Structures

Abstract

We show that exchange rate and international consumption comovements can be decomposed into components driven by trade network linkages, supply shocks, and demand shocks. Exchange rate correlations tend to be explained by trade network linkages, while consumption correlations tend to be explained by supply shock correlations. We explain this disconnect using an international network model where demand shocks are driven by market segmentation. We then show that the trade network generates common factors that align with the common factors in exchange rates. Our findings offer a trade-based account for the origins of comovements and factor structures in international asset prices and shed light on the nature of frictions in international financial markets.