Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences

29 Pages Posted: 7 Nov 2014 Last revised: 10 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 is traded internationally, then long-run risk generates insufficient exchange rate volatility. A long-run risk model with recursive-preferences can generate realistic exchange rate volatility, if all agents efficiently share their consumption risk by trading in complete financial markets; however, this entails massive international wealth transfers, and excessive swings in net foreign asset positions. By contrast, a long-run risk, recursive preferences model in which only a fraction of households trades in complete markets, while the remaining households lead hand-to-mouth lives, can generate realistic exchange rate and external balance volatility.

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

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

Suggested Citation

Kollmann, Robert, Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences (November 2014). CAMA Working Paper No. 70/2014, Available at SSRN: https://ssrn.com/abstract=2519853 or http://dx.doi.org/10.2139/ssrn.2519853

Robert Kollmann (Contact Author)

ECARES, Université Libre de Bruxelles ( email )

Ave. Franklin D Roosevelt, 50 - C.P. 114
Brussels, B-1050
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University of Paris XII - Department of Economics ( email )

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Creteil cedex, 94010
France

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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