Limited asset market participation and the consumption‐real exchange rate anomaly

Abstract Under efficient consumption risk sharing, as assumed in standard international business cycle models, a country's aggregate consumption rises relative to foreign consumption, when the country's real exchange rate depreciates. Yet empirically, relative consumption and the real exchange rate are essentially uncorrelated. This paper shows that this ‘consumption‐real exchange rate anomaly’ can be explained by a simple model in which a subset of households trade in complete financial markets, while the remaining households lead hand‐to‐mouth (HTM) lives. HTM behaviour also generates greater volatility of the real exchange rate and of net exports, which likewise brings the model closer to the data.