The consumption-real exchange rate anomaly with extensive margins

Abstract

This paper investigates a consumption-real exchange rate anomaly from the open macroeconomics literature known as the Backus-Smith puzzle . We both analytically and quantitatively examine how an expansion of trade along extensive margins can contribute to the puzzle's resolution. Our argument is based on 1) a wealth e¤ect due to changes in the number of product varieties, 2) statistical ine¢ ciency in measuring the number of product varieties, and 3) market incompleteness. Contrary to complete asset markets which, in general, feature overly strong risk sharing properties, changes in the number of product varieties under incomplete markets may produce a wealth e¤ect under high trade elasticity. Since statistical agencies systematically fail to capture the welfare impact arising from that changes, data-consistent terms of trade and real exchange rates tend to appreciate due to this positive wealth e¤ect. This provides a realistic correlation between data-consistent real exchange rates and consumption.6 I would like to thank the editor and two anonymous referees for their valuable comments. I gratefully acknowledge Philippe Martin for his advice and encouragement. I would like to also thank Nicolas Coeurdacier, Hideaki Hirata, Jan Kranich, Eiji Ogawa, Eiji Okano and Robert Kollmann for providing comments and insightful discussions. I thank all seminar participants at the Universities Rennes1, Paris1, Hitotsubashi, the 13th T2M conference, the 14th SMYE, the 25th EEA meeting and the 13th macroeconomic conference in Tokyo. The paper is based on the second chapter of my Ph.D. dissertation.

Exchange Rate Volatility and Domestic Consumption: A Comparative Study of Developed, Developing and Emerging Economies

“…Bahmani-Oskooee & Xi (2012) include the volatility of the exchange rate as another determinant of consumption in the consumption function. Employing the data from Japan, Canada, and the US, they found that the VEX (Note 2) hurts domestic consumption in case of Canada, while it demonstrates positive impact in case of US and Japan, supporting the argument of Obstfeld & Rogoff 1998. Only few empirical studies are present in the ample body of the literature on the relationship between the volatile exchange rate and the domestic consumption such as Bahmani-Oskooee and Xi (2011), Bahmani-Oskooee & Xi, (2012), Bahmani-Oskooee & Hajilee, (2012), Hamano, (2013), Bahmani-Oskooee, Kutan, & Xi, (2015). A critical review of the entire body of the concentrated literature brought off on the nexus between VEX and the domestic consumption, divulge that researchers have analysed the relationship regarding only a few economies, considering time-series data.…”

“…It is only the consumption, which gives the primary thrust to production (Campbell & Mankiw, 1989;Saha & Zhang, 2013).Moreover, the role of household aggregate consumption in the process of a country's economic growth is vital since it defines the standard of living of inhabitants, while the living standard defines the economic status of a country (Murase, 2013). Therefore, it is imperative for economists and the policymakers to understand and to identify the determinants of consumption which can encourage and curtail the economics activities during the recessionary and inflationary times respectively (Hamano, 2013).…”

“…Further, traditional determinants of consumption such as income and interest rate have received enough attention in the literature, and most of the studies argued that income and interest rate are the key determinants of consumption (Hamano, 2013). A few reviews explained that inflation is also the determinant of consumption, as inflation can affect the level of consumption (Kugler, 1985;Villagomez, 1994).…”

International equity and bond positions in a DSGE model with variety risk in consumption

“…Without fixed export costs, we have four fewer variables and four fewer equations. The supply side of the model collapses to the one similar to Hamano (2013).…”

Stability and cooperative solution in stochastic games

“…This pattern, known as the Backus-Smith Puzzle, is even more surprising given the rise in international capital flows and the progressive integration of world financial markets. Masashige Hamano 42 presents a possible resolution of the puzzle based on three elements: (i) a wealth effect due to changes in the number of product varieties; (ii) statistical inefficiency in measuring the number of product varieties; and (iii) market incompleteness.…”