International Risk Sharing: Through Equity Diversification or Exchange Rate Hedging?

October 28, 2009

by Charles Engel and Akito Matsumoto

Well-known empirical puzzles in international macroeconomics concern the large divergence of equilibrium outcomes for consumption across countries from the predictions of models with full risk sharing. It is commonly believed that these risk-sharing puzzles are related to another empirical puzzle-the home-bias in equity puzzle. However, we show in a series of dynamic models that the full risk sharing equilibrium may not require much diversification of equity portfolios when there is price stickiness of the degree typically calibrated in macroeconomic models. This conclusion holds under a range of assumptions about home bias in preferences, price setting as PCP or LCP, and with or without nominal wage stickiness as long as there is some price rigidity.

The authors show that Cole and Obstfeld (1991) result that terms of trade adjustments provide for the majority of the risk-sharing benefits is only true when prices are flexible. In a log-linearized version of a two-country DSGE model with sticky prices, trade in only equities achieves complete risk sharing. For many parametrizations, households are long on home equity and short on foreign equity, so that an unexpected currency depreciation which has positive income effects under sticky prices is offset by a negative wealth shock to the portfolio. As with the results of, e.g., Devereux and Sutherland (2008), it may be interesting to see the implications of inefficient portfolio selection due to imperfect information, uncertainty, etc.

Estimating the border effect: some new evidence

October 18, 2009

by Gita Gopinath, Pierre-Olivier Gourinchas, Chang-Tai Hsieh, Nicholas Li

To what extent do national borders and national currencies impose costs that segment markets across countries? To answer this question the authors use a dataset with product-level retail prices and wholesale costs for a large grocery chain with stores in the United States and Canada. They develop a model of pricing by location and employ a regression discontinuity approach to estimate and interpret the border effect. They report three main facts: One, the median absolute retail price and wholesale cost discontinuities between adjacent stores on either side of the U.S.-Canadian border are as high as 21 percent. In contrast, within-country border discontinuity is close to 0 percent. Two, the variation in the retail price gap at the border is almost entirely driven by variation in wholesale costs, not by variation in markups. Three, the border gaps in prices and costs co-move almost one-to-one with changes in the U.S.-Canadian nominal exchange rate. They show these facts suggest that the price gaps they estimate provide only a lower bound on border costs.

The authors build a two-country model of horizontal differentiation based on Salop’s (1979) circular city model in which degree of segmentation is endogenous and depends on the sizes of countries, distance from the border and substitutability across locations. The model itself provides numerous novel predictions and can account for a number of properties of prices across borders. The authors then discontinuity regression approach on a scanner price dataset of a large US & Canadian retailer to document how the model can match several interesting properties of prices across borders. A very interesting contribution.