International Risk Sharing and the Transmission of Productivity Shocks

Abstract

A central puzzle in international finance is that real exchange rates are volatile and, in stark contradiction to efficient risk sharing, negatively correlated with cross-country consumption ratios. This Paper shows that a standard international business cycle model with incomplete asset markets augmented with distribution services can account quantitatively for these properties of real exchange rates. Distribution services, intensive in local inputs, drive a wedge between producer and consumer prices, thus lowering the impact of terms-of-trade changes on optimal agents’ decisions. This reduces the price elasticity of tradables separately from assumptions on preferences. Two very different patterns of the international transmission of positive technology shocks generate the observed degree of risk sharing: one associated with improving, the other with deteriorating terms of trade and real exchange rate. In both cases, large equilibrium swings in international relative prices magnify consumption risk due to country-specific shock, running counter to risk sharing. Suggestive evidence on the effect of productivity changes in US manufacturing is found in support of the fist transmission pattern, questioning the presumption that terms-of-trade movements in response to supply shocks invariably foster international risk pooling.