Transport Costs, Relative Prices, and International Risk Sharing

Abstract

This paper studies the role of the transport costs in accounting for the puzzling behaviors of relative prices and risk sharing across countries. We show that introducing the transport costs in an otherwise standard competitive model improves its ability to rationalize the deviations from the law of one price and imperfect international risk sharing. Our analysis suggests that the purchasing power parity puzzle and the consumption correlation puzzle can naturally arise in the presence of real frictions, even under the assumption of complete financial markets.