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 effect due to changes in the number of product varieties, 2) statistical inefficiency 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 effect 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 effect. This provides a realistic correlation between data-consistent real exchange rates and consumption. •The Backus-Smith can be attenuated with changes in the number of product varieties.•The key is a wealth effect due to changes in extensive margins.•Another key is the statistical inefficiency in measuring them.•Market incompleteness is also required to achieve the result.
| Original language | English |
|---|---|
| Pages (from-to) | 26-46 |
| Number of pages | 21 |
| Journal | Journal of International Money and Finance |
| Volume | 36 |
| DOIs | |
| Publication status | Published - 2013 Sep |
| Externally published | Yes |
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Keywords
- Firm entry
- Terms of trade
- The Backus-Smith puzzle
ASJC Scopus subject areas
- Economics and Econometrics
- Finance
Cite this
The consumption-real exchange rate anomaly with extensive margins. / Hamano, Masashige.
In: Journal of International Money and Finance, Vol. 36, 09.2013, p. 26-46.Research output: Contribution to journal › Article
}
TY - JOUR
T1 - The consumption-real exchange rate anomaly with extensive margins
AU - Hamano, Masashige
PY - 2013/9
Y1 - 2013/9
N2 - 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 effect due to changes in the number of product varieties, 2) statistical inefficiency 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 effect 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 effect. This provides a realistic correlation between data-consistent real exchange rates and consumption. •The Backus-Smith can be attenuated with changes in the number of product varieties.•The key is a wealth effect due to changes in extensive margins.•Another key is the statistical inefficiency in measuring them.•Market incompleteness is also required to achieve the result.
AB - 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 effect due to changes in the number of product varieties, 2) statistical inefficiency 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 effect 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 effect. This provides a realistic correlation between data-consistent real exchange rates and consumption. •The Backus-Smith can be attenuated with changes in the number of product varieties.•The key is a wealth effect due to changes in extensive margins.•Another key is the statistical inefficiency in measuring them.•Market incompleteness is also required to achieve the result.
KW - Firm entry
KW - Terms of trade
KW - The Backus-Smith puzzle
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U2 - 10.1016/j.jimonfin.2013.03.001
DO - 10.1016/j.jimonfin.2013.03.001
M3 - Article
AN - SCOPUS:84877335790
VL - 36
SP - 26
EP - 46
JO - Journal of International Money and Finance
JF - Journal of International Money and Finance
SN - 0261-5606
ER -