Real exchange rate variability in a two-country business cycle model

Abstract

This paper shows that introducing recursive preferences in a standard two-country business cycle model implies a real exchange rate as volatile as in the data. With recursive preferences the marginal utility of consumption today depends on innovations in future utilities. Productivity shocks with a unit root have long-term effects and home bias implies that the effects differ across countries. A positive shock in one country therefore leads to a larger drop in marginal utility in that country. There is then a strong depreciation of the real exchange rate and resources are transferred abroad due to risk-sharing between households. This leads to a volatile real exchange rate and can imply positive cross-country correlations in both investment and employment. Innovations to future utilities imply volatile stochastic discount factors which are necessary to price financial assets. The paper therefore bridges the gap between models in international macroeconomics and finance.