Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences

29 Pages Posted: 3 Nov 2014

See all articles by Robert Kollmann

Robert Kollmann

ECARES, Université Libre de Bruxelles; University of Paris XII - Department of Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: November 2014

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

Suggested Citation

Kollmann, Robert, Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences (November 2014). CEPR Discussion Paper No. DP10232, Available at SSRN: https://ssrn.com/abstract=2518718

Robert Kollmann (Contact Author)

ECARES, Université Libre de Bruxelles ( email )

Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
Belgium

University of Paris XII - Department of Economics ( email )

61 avenue du General de Gaulle
Creteil cedex, 94010
France

HOME PAGE: http://www.robertkollmann.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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