Answer to Question #42145 in Macroeconomics for Flavia

Question #42145
Hello, and thank you in advance:) I'm trying to figure out whether there is a relationship between within country income inequality and different exchange rate regimes. Now I'm in the process of selecting my cases (countries). I was thinking of making a comparison of countries going through the same process starting from the Bretton Woods System through the EMR (2.25) & EMR (15) up to the EMU. Like this I was hoping to see whether the change from one system to another has any implications on the Gini and Theil-Index for those countries. It would aso make a time series comparison of countries a lot easier, given that countries change their exchange rate regimes quite often, and results can vary widely if different classifications for exchange rate regimes are used. Now given that my knowledge of macroeconomics is still rather limited, I wanted to know whether this procedure is any good, or if it would make more sense to compare time series of different exchange rate regimes (i.e. UK from 1973-today vs. US
Expert's answer
In a classic paper, Backus and Smith (1993) prove that if asset marketsare frictionless, then the growth rate of the real exchange rate should be perfectly correlated with between-country differences in per capital consumption growth. However, they also show that this implication is dramatically falsified in data on OECD countries: The correlation between the growth of the real exchange rate and between-country differences in per capital consumption growth is basically zero (or even negative in more
recent periods). It follows that asset markets cannot be truly frictionless.

However, what friction is actually responsible for this disconnect between theory and data is still not well understood (as argued by Chari, Kehoe, and McGrattan (2002) among others).

Here we aim toward identifying the relevant asset market friction. We build on recent work by Kocherlakota and Pistaferri (2007; hereafter KP). They show that the theoretical connection between consumption growth rates and real exchange rates relies on the assumption that there is a representative agent in each country. In particular, KP show that the connection breaks down if households within a country are only partially insured against idiosyncratic shocks such as disability, unemployment, or wage
fluctuations. Instead, under partial insurance, economic theory implies that real exchange rates should be correlated with between-country differences in the growth rate of consumption inequality.

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