Exchange Rate Dynamics, Asset Market Structure and the Role of the Trade Elasticity

This paper shows that a canonical flexible price international real business cycle model with incomplete financial markets can address the exchange rate volatility puzzle, the exchange rate persistence puzzle, the consumption real exchange rate anomaly, as well as the quantity anomaly. Crucial for the success of the model is the choice of the elasticity of substitution between home and foreign produced goods. The paper shows that the range of this parameter which allows the model to address these international macroeconomics anomalies is very narrow. Furthermore, the paper highlights an anomalous relationship between real exchange rate persistence and the elasticity of substitution between home and foreign-produced goods.