Asset Prices and Real Exchange Rates with Deep Habits

Abstract:     
I study a two-country, two-good pure-exchange economy with deep habits and consumption home bias. The model jointly accounts for the volatility of the real exchange rate, equity premiums, stock return volatilities and the levels and volatilities of the risk free rates. I show that deep habits simultaneously produce an upward-sloping real yield curve and the failure of the uncovered interest rate parity, a feature that is difficult to produce with standard models. Deep habit formation, in contrast to standard habit formation, creates a wedge between the exchange rate and relative consumption of domestic and foreign goods which simultaneously allows for high volatility of the exchange rate and low volatility of consumption of domestic and foreign goods.

Number of Pages in PDF File: 69

Keywords: Asset Pricing Moments, Real Exchange Rates, Multi-Good Economies, Deep Habits

JEL Classification: F31, G10

working papers series