Borders and Nominal Exchange Rates in Risk-Sharing

Abstract

Models of risk-sharing predict that relative consumption growth rates across locations should be positively related to real exchange rate growth rates across the same areas. We investigate this hypothesis using a new multi-country and multi-regional data set. Within countries, we find evidence for risk-sharing: episodes of high relative regional consumption growth are associated with regional real exchange rate depreciation. Across countries however, the association is reversed: relative consumption and real exchange rates are negatively correlated. We define this reversal as a border effect and show that it accounts for 53 percent of the deviations from full risk-sharing. Since cross-border real exchange rates involve different currencies, it is natural to ask how much of the border effect is accounted for by movements in exchange rates? We find that over one-third of the border effect is due to nominal exchange rate fluctuations. We develop a simple open economy model that is consistent with the importance of nominal exchange rate variability in accounting for deviations from cross-country risk-sharing.

Keywords: Real exchange rate, risk sharing, border effect, intranational economics

JEL Classification: F3, F4