Consumption Dynamics and Real Exchange Rates

Abstract

The Paper investigates the role of the real exchange rate in relationships between consumption growth rates across countries when financial markets are integrated. The real exchange rate introduces a wedge between real marginal utilities of consumption in different countries and this wedge plays a prominent role in a number of new theories of international fluctuations. Yet, the role of the real exchange rate has been ignored in many previous studies of risk sharing and financial market integration. We find a limited role for the real exchange rate in these relationships. Special attention is also paid to the analysis of non-separabilities in the utility function including effects of money balances, leisure, government spending, and habit persistence. The results are also shown to be robust to decomposing consumption. The evidence may question the empirical plausibility of recent theories of international business cycles that associate a crucial role to the real exchange rate in breaking the direct link between consumption in different countries.

Keywords: Consumption risk sharing, habit persistence, non-separabilities, real exchange rates

JEL Classification: E21, E32, E41