Dynamics of Real Exchange Rates and Trade Balance in the Presence of Heterogeneous Preferences and Incomplete Financial Markets
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When agents across countries have home-biased preferences in a world of incomplete financial markets, an increase in the relative price of home-produced goods resulted from a permanent adverse home output shock makes the cost of living of home agents higher than that of foreign agents [appreciation of real exchange rate], reducing home relative consumption. Intertemporal utility maximizing agents with the degree of relative risk aversion greater than unity in the CES utility function would like to smooth their relative consumption by reducing exports and increasing imports, resulting in trade deficit.
Abstract
When agents across countries have home-biased preferences in a world of incomplete financial markets, an increase in the relative price of home-produced goods resulted from a permanent adverse home output shock makes the cost of living of home agents higher than that of foreign agents [appreciation of real exchange rate], reducing home relative consumption. Intertemporal utility maximizing agents with the degree of relative risk aversion greater than unity in the CES utility function would like to smooth their relative consumption by reducing exports and increasing imports, resulting in trade deficit.
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