Robust Control, Informational Frictions, and International Consumption Correlations

40 Pages Posted: 27 Nov 2013 Last revised: 25 Sep 2022

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Date Written: November 27, 2013

Abstract

This working paper was written by Yulei Luo (The University of Hong Kong), Jun Nie (Federal Reserve Bank of Kansas City) and Eric R. Young (University of Virginia).

In this paper we examine the effects of model misspecification (robustness or RB) on international consumption correlations in two otherwise standard small open economy models: one with perfect state observation and the other with imperfect state observation. We show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model with perfect state observation cannot explain the observed consumption correlations quantitatively. We then show that the RB model with imperfect state observation is capable of matching the behavior of international consumption quantitatively via two channels: (i) the gradual response to income shocks that increases the correlations and (ii) the presence of the common noise shocks that reduce the correlations.

Keywords: Robustness, Imperfect State Observation, International Consumption Correlations

JEL Classification: D83, E21, F41, G15

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, Robust Control, Informational Frictions, and International Consumption Correlations (November 27, 2013). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 21/2013, Available at SSRN: https://ssrn.com/abstract=2360434 or http://dx.doi.org/10.2139/ssrn.2360434

Hong Kong Institute for Monetary and Financial Research (Contact Author)

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