International Risk-Sharing and the Transmission of Productivity Shocks

This paper shows that a model with incomplete markets and a low price elasticity of imports can account for these properties of real exchange rates. The low price elasticity stems from introducing distribution services, which drive a wedge between producer and consumer prices and lowers the impact of terms-of-trade changes on optimal agents’ decisions.

In the authors' model, two very different patterns of the international transmission of productivity shocks generate the observed degree of risk-sharing: one associated with an improvement, the other with a worsening of the country’s terms of trade and real exchange rate. They provide VAR evidence on the effect of technology shocks to U.S. manufacturing, identified through long-run restrictions, in support of the first transmission pattern. These findings are at odds with the presumption that terms-of-trade movements foster international risk-pooling.