Asset Market Frictions in Quantitative International Business Cycle Models

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

The central puzzle in international business cycles is that real exchange rates are volatile, persistent, and not closely related to macroeconomic aggregates. These exchange rate fluctuations are explained by the interaction of monetary shocks and sticky prices. However, researchers have not yet developed quantitative general equilibrium models that support this explanation. The first generation of quantitative equilibrium models of international fluctuations from over a decade ago document that complete market models with technology shocks have a hard time generating the observed patterns of exchange rates. This project consists of three parts which model specific frictions discussed in the literature and assesses their ability to better account for the observations. The first part considers simple frictions such as incomplete markets. The second part considers the friction due to the difficulty of enforcing contracts between sovereign nations. These contracts involve large transfers of resources, which are only backed by promises to pay later. In the third part frictions are due to fixed cost to access the asset markets. More specifically, this project introduces sticky prices, monetary shocks and monopolists who price to market internationally into a quantitative equilibrium model of international fluctuations. This model can generate volatile and persistent real exchange rates, as in the data. The main discrepancy between the model and the data is the high correlation between real exchange rates and relative consumptions while the data shows no clear pattern between these variables. This anomaly will occur in any model with frictionless asset markets because in such a model the real exchange rate is tightly linked to the marginal utilities of consumption of domestic and foreign agents. The theoretical research shows that friction due to incomplete markets, international loans that can be enforced only by the threat of exclusion from future borrowing, and fixed costs to exchange bonds and money in international markets break the tight link between real exchange rates and relative consumptions present in frictionless models by introducing a stochastic wedge between the real exchange rate and the ratio of marginal utilities. The project investigates the quantitative significance of the different types of frictions. Preliminary results suggest that these frictions can go a long way in resolving the consumption-real exchange rate anomaly and at the same time generate other observed characteristics of the data.