Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences

Standard macro models cannot explain why real exchange rates are volatile and disconnected from macro aggregates. Recent research argues that models with persistent growth rate shocks and recursive preferences can solve that puzzle. I show that this result is highly sensitive to the structure of financial markets. When just a bond is traded internationally, then long-run risk generates insufficient exchange rate volatility. A long-run risk model with recursive-preferences can generate realistic exchange rate volatility, if all agents efficiently share their consumption risk by trading in complete financial markets; however, this entails massive international wealth transfers, and excessive swings in net foreign asset positions. By contrast, a long-run risk, recursive-preferences model in which only a fraction of households trades in complete markets, while the remaining households lead hand-to-mouth lives, can generate realistic exchange rate and external balance volatility. JEL codes: F31, F36, F41, F43, F44 * Robert Kollmann, European Centre for Advanced Research in Economics and Statistics, (ECARES), CP 114, Université Libre de Bruxelles, 50 Av. Franklin Roosevelt, B-1050 Brussels, Belgium. 32-2-6504474. [email protected]. This is a substantially revised version of my 2009 working paper ‘EZW in a World Economy’. I thank Simona Cociuba, Mariano Croce, Chris Erceg, Werner Roeger, Philippe Weil, Raf Wouters, and workshop participants at the Federal Reserve Board and at the Dallas Fed (November 2009) for useful discussions.The views in this paper are those of the author and do not necessarily reflect the views of the European Centre for Advanced Research in Economics and Statistics, the Federal Reserve Bank of Dallas or the Federal Reserve System.