Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/93444
Authors: 
Caporale, Guglielmo Maria
Donadelli, Michael
Varani, Alessia
Year of Publication: 
2014
Series/Report no.: 
CESifo Working Paper 4669
Abstract: 
A canonical two country-two good model with standard preferences does not address three classic international macroeconomic puzzles as well as two well-known asset pricing puzzles. Specifically, under financial autarky, it does not account for the high real exchange rate (RER) volatility relative to consumption volatility (RER volatility puzzle), the negative RER-consumption differentials correlation (Backus-Smith anomaly), the relatively low cross-country consumption correlation (consumption correlation puzzle), the low risk-free rate (risk-free rate puzzle) and the high equity risk premium (equity premium puzzle) in the data. In this paper, we show that instead a two country-two good model with recursive preferences, international complete markets and correlated long-run innovations can address all five puzzles for a relatively large range of parameter values, specifically in the case of the US and China. Therefore, in contrast to other IBC models, its performance does not rely on any financial market imperfections.
Subjects: 
financial autarky
complete markets
long-run risk
anomalies
JEL: 
F30
F40
Document Type: 
Working Paper

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