The international risk sharing puzzle is at business cycle and lower frequency

Abstract

We decompose the correlation between relative consumption and the real exchange rate in its dynamic components at different frequencies. Using multivariate spectral analysis techniques, we show that, at odds with a high degree of risk sharing, in most OECD countries the dynamic correlation tends to be quite negative, and significantly so, at frequencies lower than two years – the appropriate frequencies for assessing the performance of international business cycle models. Theoretically, we show that the dynamic correlation over different frequencies predicted by standard open economy models is the sum of two terms: a term constant across frequencies, which can be negative when uninsurable risk is large; a term variable across frequencies, which in bond economies is necessarily positive, reflecting the insurance intertemporal trade provides against forecastable contingencies. Numerical analysis suggests that leading mechanisms proposed by the literature to account for the puzzle are consistent with the evidence across the spectrum.

International risk sharing during the globalization era

“…Adding one or more frictions, 10 such as non‐tradables, home bias in consumption, price rigidity in local currency, and so on, makes it difficult to derive a simple international risk‐sharing measure that can be applied to a large set of countries. Note that in order to develop a simple measure, we abstract from possible risk‐sharing improvements that come through international price movements, as shown by Cole and Obstfeld (1991) and Corsetti, Dedola, and Leduc (2008).…”

Does financial integration affect real exchange rate volatility and cross-country equity market returns correlation?

“…Please cite this article in press as: Donadelli Corsetti et al (2012), we decompose the Backus-Smith correlation in its dynamic components at different frequencies. Low frequency (gray line): 3-8 years; high frequency (black line): 2-5 years.…”

“…Over this period, the Backus-Smith correlation is equal to −0.31. In the spirit of Corsetti, Dedola, and Viani (2012), using the bandpass filter decomposition described in Christiano and Fitzgerald (2003), we re-compute the correlation under different frequency scenarios. Fig.…”

Can International Macroeconomic Models Explain Low-Frequency Movements of Real Exchange Rates?

“…Baxter (2011) …nds that there is evidence in favor of risk sharing across countries at medium and low frequencies. Corsetti, Dedola, and Viani (2011) study the correlation between the RER and the ratio of consumption levels across countries (which is known as the "Backus-Smith puzzle") at both BC and low frequencies.…”