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We study the impact of foreign debt on transmission of productivity shocks and on international risk sharing in a two-country DSGE model with incomplete asset markets and deviations from the purchasing power parity. We elucidate two channels through which debt affects international shock transmission. First, changes in domestic output cause fluctuations in the debt-to-GDP ratio and thus affect the risk premium on foreign borrowing. Second, fluctuations in the real exchange rate alter the real value of existing liabilities, generating wealth effects for the consumers in the indebted economy. Together, these two channels help to address the Backus-Smith puzzle by producing a negative consumption-real exchange rate correlation in an environment driven by productivity shocks. Our findings are robust to monetary policy rule specification but depend critically on the currency of debt denomination.

International transmission of productivity shocks with nonzero net foreign debt