International Asset Markets And Real Exchange Rate Volatility

The real exchange rate is very volatile relative to major macroeconomic aggregates and its correlation with the ratio of domestic over foreign consumption is negative (Backus-Smith puzzle). These two observations constitute a puzzle to standard international macroeconomic theory. This paper develops a two country model with complete asset markets and limited enforcement for international financial contracts that provides a possible explanation of these two puzzles. The model performs poorly with respect to asset pricing. However, with limited enforcement for both domestic and international financial contracts, the model’s asset pricing implications are brought into line with the empirical evidence, albeit at the expense of raising real exchange rate volatility.