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Staff Report 372

Household Heterogeneity and Real Exchange Rates

Narayana Kocherlakota Consultant
Luigi Pistaferri

Published April 1, 2006

Abstract
Typical incomplete markets models in international economics make two assumptions. First, households are not able to fully insure themselves against country-specific shocks. Second, there is a representative household within each country, so that households are fully insured against idiosyncratic shocks. We assume instead that cross-household risk-sharing is limited within countries, but cross-country risk-sharing is complete. We consider two types of limited risk-sharing: domestically incomplete markets (DI) and private information-Pareto optimal (PIPO) risk-sharing. We show that the models imply distinct restrictions between the cross-sectional distributions of consumption and real exchange rates. We evaluate these restrictions using household-level consumption data from the United States and the United Kingdom. We show that the PIPO restriction fits the data well when households have a coefficient of relative risk aversion of around 5. The analogous restrictions implied by the representative agent model and the DI model are rejected at conventional levels of significance.



Published In: Economic Journal (Vol. 117, 2007, pp. C1-C25)

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