Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences

Abstract

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 can be traded internationally, then long-run risk generates insufficient exchange rate volatility. A longrun risk model with recursive-preferences in which all agents trade in complete global financial markets can generate realistic exchange rate volatility; however, I show that this entails huge international wealth transfers, and excessive swings in net foreign asset positions. By contrast, a long-run risk, recursive-preferences model in which only a small fraction of households trades in complete markets, while the remaining households lead hand-to-mouth lives, generates realistic exchange rate and external balance volatility

Keywords: complete financial markets, exchange rate, financial frictions, international risk sharing, long-run risk, recursive preferences

JEL Classification: F31, F36, F41, F43, F44