Consumption Dynamics and Real Exchange Rates

Abstract

The paper investigates the role of the real exchange rate in international risk sharing relationships. 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. The paper shows that the risk sharing hypothesis is rejected for a panel of OECD countries and that it is the introduction of the real exchange rate that allows one to reach robust conclusions. In particular, while foreign consumption often enters significantly into the risk sharing relationships, the real exchange rate is rarely significant. 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.

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

JEL Classification: E21, E32, E41