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Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences

Robert Kollmann ()

Open Economies Review, 2015, vol. 26, issue 2, 175-196

Abstract: Standard macro models fail to 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 may 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. Copyright Springer Science+Business Media New York 2015

Keywords: Exchange rate; Long-run risk; Recursive preferences; Complete financial markets; Financial frictions; International risk sharing; F31; F36; F41; F43; F44 (search for similar items in EconPapers)
Date: 2015
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Working Paper: Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences (2014) Downloads
Working Paper: Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences (2014) Downloads
Working Paper: Exchange Rates Dynamics with Long-Run Risk and Recursive Preferences (2014) Downloads
Working Paper: Exchange rates dynamics with long-run risk and recursive preferences (2014) Downloads
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