Understanding the Backus-Smith puzzle: It's the (nominal) exchange rate, stupid

Gregory D. Hess, Kwanho Shin

Research output: Contribution to journalArticle

6 Citations (Scopus)

Abstract

Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3-4), 297-316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to 'rule of thumb' consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.

Original languageEnglish
Pages (from-to)169-180
Number of pages12
JournalJournal of International Money and Finance
Volume29
Issue number1
DOIs
Publication statusPublished - 2010 Feb 1

Fingerprint

Nominal exchange rate
Consumption growth
Real exchange rate
Output growth
Risk sharing
Rules of thumb
International capital markets
International economics
OECD countries
U.S. States
Robustness
Impediments
Inflation differentials
Imperfections
Violations

Keywords

  • Consumption growth correlation
  • Exchange rate
  • Non-trade goods
  • Output growth correlation
  • Risk sharing

ASJC Scopus subject areas

  • Economics and Econometrics
  • Finance

Cite this

Understanding the Backus-Smith puzzle : It's the (nominal) exchange rate, stupid. / Hess, Gregory D.; Shin, Kwanho.

In: Journal of International Money and Finance, Vol. 29, No. 1, 01.02.2010, p. 169-180.

Research output: Contribution to journalArticle

@article{2a9a57efeaf04d3f849e5ecee16da6b3,
title = "Understanding the Backus-Smith puzzle: It's the (nominal) exchange rate, stupid",
abstract = "Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3-4), 297-316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to 'rule of thumb' consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.",
keywords = "Consumption growth correlation, Exchange rate, Non-trade goods, Output growth correlation, Risk sharing",
author = "Hess, {Gregory D.} and Kwanho Shin",
year = "2010",
month = "2",
day = "1",
doi = "10.1016/j.jimonfin.2009.07.005",
language = "English",
volume = "29",
pages = "169--180",
journal = "Journal of International Money and Finance",
issn = "0261-5606",
publisher = "Elsevier BV",
number = "1",

}

TY - JOUR

T1 - Understanding the Backus-Smith puzzle

T2 - It's the (nominal) exchange rate, stupid

AU - Hess, Gregory D.

AU - Shin, Kwanho

PY - 2010/2/1

Y1 - 2010/2/1

N2 - Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3-4), 297-316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to 'rule of thumb' consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.

AB - Backus, Kehoe and Kydland (BKK 1992) demonstrated that if international capital markets are complete, consumption growth correlations across countries should be higher than their corresponding output growth correlations. In stark contrast to the theory, however, in actual data the consumption growth correlation is lower than the output growth correlation. By assuming trade imperfections due to non-traded goods, Backus, D.K., Smith, G.W. [1993 Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics 35(3-4), 297-316] showed that there is an additional impediment at work that can lower the consumption growth correlation. While their argument was successful in partially explaining the puzzlingly low cross country correlation of consumption growth rates, it contributed to generating another puzzle because the data forcefully show that consumption growth is negatively correlated with the real exchange rate, which is also a violation of the theory. Using data for OECD countries, we decompose real exchange rate growth into its nominal exchange rate growth and inflation differential components, and find that nominal exchange rate movements are the main source for the Backus-Smith puzzle. We demonstrate the robustness of this finding by examining sub-samples of the data, by allowing for imperfect risk sharing due to 'rule of thumb' consumers, and by examining intranational data across the U.S. states where the nominal exchange rate is fixed.

KW - Consumption growth correlation

KW - Exchange rate

KW - Non-trade goods

KW - Output growth correlation

KW - Risk sharing

UR - http://www.scopus.com/inward/record.url?scp=72649104119&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=72649104119&partnerID=8YFLogxK

U2 - 10.1016/j.jimonfin.2009.07.005

DO - 10.1016/j.jimonfin.2009.07.005

M3 - Article

AN - SCOPUS:72649104119

VL - 29

SP - 169

EP - 180

JO - Journal of International Money and Finance

JF - Journal of International Money and Finance

SN - 0261-5606

IS - 1

ER -