Abstract
We propose a fully flexible, complete-market model of the international business cycle that is consistent with a negative correlation between the real exchange rate and relative consumption (the Backus-Smith puzzle). We allow for imperfect substitutability of capital which significantly reinforces Harrold-Balassa-Samuelson effects, producing more empirically relevant movements in real exchange rates. Most importantly, we introduce changes in expectations (news-shocks) as an explanation to the Backus-Smith puzzle, through shifts in relative demand. However, news-shocks also contribute to lower cross-country correlations of economic aggregates, deteriorating international co-movement.
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