International Puzzles

Based upon Obstfeld, M. and K. Rogoff (2000) “The Six Major Puzzles in
International Macroeconomics: Is there a Common Cause?". Four are “quantity
puzzles” and two are “price puzzles”. There are some other puzzles and data
facts which follow.

1 Puzzle 1: Home bias in international trade.

• McCallum (1995, AER) found trade among individual Canadian provinces
was 20 times greater than between Canadian provinces and individual
U.S., controlling for distance, trading partner sizes, and other factors.
• Simple augmented “gravity” regressions of the form:1
xij = a + b · yi + c · yj + d · distij + e · dummyij + uij
where xij is shipments of goods from region i to region j in logs, yi and
yj are log GDP in regions i and j, distij is the log of distance between
region i and j, dummy equals 1 for interprovince trade and 0 for province
to state trade. So the “augmentation” is the dummy variable.
• McCallum finds
b c d e
coeff 1.21 1.06 -1.42 3.09
se 0.03 0.03 0.06 0.13
The estimate for e implies exp(3.09)=22. Hence national borders matter.
• O-R introduce “border costs”: tariffs, nontariff barriers, exchange rate
risk. In one section they show how costs of international trade can dra-
matically skew domestic consumption in terms of home produced-goods.
• How big do border costs have to be to explain the home bias puzzle?
Important factor is the elasticity of substitution between home and foreign
goods.

1.1 Theory
• preferences:
³ ´θ/(θ−1)
(θ−1)/θ (θ−1)/θ
U (CH , CF ) = CH + CF

where CH is home consumption of home good (country one consumption of

good 1), CF is home consumption of foreign good (country 1 consumption
of good 2).
1 From wiki - The gravity model of trade in international economics predicts bilateral trade

flows based on the economic sizes of (often using GDP measurements) and distance between
two units.

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• endowments: home agents endowed with Y units of home good (good 1).
• prices: PH is the home price of the home good, PF is the home price of the
foreign good all in terms of a common currency (since flex price model,
the common currency assumption doesn’t matter).
• Iceberg costs: every unit of home (foreign) good shipped abroad yields
(1 − τ ) in the other country.
• Competitive markets.
• All foreign variables are with ∗ . For example, CH ∗
is the country 2 con-
sumption of good 1, CF is the country 2 consumption of good 2, Y ∗ is
∗
∗
country 2 production of good 2, PH is the price of good 1 in country 2,
∗
PF is the price of good 2 in country 2.
• Arbitrage: PF = PF∗ /(1−τ ) and PH = (1−τ )PH ∗
. To see where this comes
from, if an H resident buys 1 foreign good at home, 1 unit costs PF . In
order to buy one unit of the foreign good in the foreign country and ship
it back to the home country, the H resident must pay PF∗ /(1 − τ ) (i.e.
he must buy more than one foreign good (i.e. 1/(1 − τ ) foreign goods)
because only (1−τ ) of 1/(1−τ ) will arrive after they melt away). Suppose
PF > PF∗ /(1 − τ ), then home residents buy the foreign good abroad and
ship it back. The excess demand from H residents in the foreign country
raises PF∗ until equality.
PF
• Taking the ratio of the arbitrage conditions and letting p ≡ PH (i.e. the
P∗
relative price of good 2 in terms of good 1 in the home country), p∗ ≡ PF∗
H
(i.e. the relative price of good 2 in terms of good 1 in the foreign country):

(1 − τ )PF PF∗ 2 ∗
= ∗ ⇐⇒ (1 − τ ) p = p . (1)
PH (1 − τ )PH

• Notice that this arbitrage condition says that there is a “wedge” between
the relative prices of two goods across countries depending on the size
of the “border costs”. If border costs are zero, then there can be no
difference.
• How might those border costs be magnified?
• Optimization
³ ´θ/(θ−1)
(θ−1)/θ (θ−1)/θ
max CH + CF
CH ,CF
PF
s.t.CH + CF = Y
PH

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 • f.o.c.
³ ´1/(θ−1)
(θ−1)/θ (θ−1)/θ −1/θ
CH : CH + CF CH =μ
³ ´1/(θ−1) PF
(θ−1)/θ (θ−1)/θ −1/θ
CF : CH + CF CF =μ
PH
or
1/θ
CH PF CH
1/θ
= ⇐⇒ = pθ . (2)
CF PH CF
∗
CH
Similarly, ∗
CF = p∗θ .

• Elasticity of substitution between goods in response to a relative price

change: ³ ´
d C H
CF p p
· ³ ´ = θpθ−1 · θ = θ.
dp CH p
CF

That is, as the price of the foreign good rises relative to the home good,
agents substitute out of the foreign good and into the home good the
higher is the elasticity.
• In this two-country framework, this elasticity will determine how imports
and exports react to price and tariff changes.

1.2 Characterizing home bias in trade

• For simplicity, consider the completely symmetric case where Y = Y ∗ (i.e.
both countries produce the same amount of the two goods and both have
symmetric preferences). Then
CF C∗
= H . (3)
CH CF∗
i.e. with symmetry, the ratios of imported goods to domestically consumed
goods should be identical across countries.
• Then (1), (2), (3) can be manipulated to imply the ratio of home expen-
diture on home goods relative to imports is
CH
= (1 − τ )1−θ .
pCF
CH
• Thus, if there were no trade costs, pCF = 1.
• Data from OECD countries suggest that ³ the ratio
´ of expenditure on do-
CH
mestic goods to foreign goods is 4.2 = pCF . Thus, if θ = 6 which
falls within the range of estimates by other studies, then this implies τ is
roughly 0.25 (i.e. 4.2 = (1 − 0.25)−5 ).
• While 0.25 seems high, can lower τ as long as raise θ.

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2 Puzzle 2: Capital Immobility (Home bias in
saving)
• Feldstein and Horioka (1980, EJ) found that long-period averages (1960-
1974) of national savings rates are highly correlated with long-period av-
erages of investment rates for OECD countries (not so surprising for de-
veloping countries with high sovereign default risk).
• Simple regressions of the form:
µ ¶ µ ¶
I S
=a+b· + ui
Y i Y i
¡ ¢ ¡ ¢
where YI i and YS i are gross domestic investment / savings to gross
domestic product in country i, respectively.
• F-H find b = 0.9. More recent regressions find b = 0.6, but still high in a
world of fully integrated capital markets where global savings should flow
to regions with the highest rates of return (if the country is small relative
to the rest of the world, b = 0).
• Baxter and Crucini (1993, AER) Table 1 - Using time series data, bigger
countries have bigger savings-investment correlations. This make some
sense since bigger countries do not take interest rates as given.

Country GDP in $ S-I correlation

US 3,994 0.86
Japan 1,365 0.80
WG 667 0.68
France 527 0.31
Italy 372 0.39
Canada 347 0.61
Australia 171 0.54
Sui 106 0.65

2.1 Theory
• To study savings and investment, need a dynamic framework. Baxter
and Crucini (1993, AER) show that the larger is the country, the larger b
should be in an RBC framework.
• O-R show that you can generate a home bias in saving (i.e. saving that
does not respond to interest rate differentials) through a dynamic version
of the environment with iceberg costs.

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3 Puzzle 3: Home bias in Equity Portfolios
• French and Poterba (1991,AER) found that Americans held roughly 94%
of their equity wealth in the U.S. stock market and Japanese held 98% of
their equity at home. While Tesar and Werner (1998, Brookings Papers)
have documented that this number has fallen since the 1987 Stock Market
Crash it is still very high.

4 Puzzle 4: Low Consumption Risk Sharing -

the quantity puzzle.
• Backus, Kehoe, and Kydland (1992, JPE or 1993, FRBMQR, Table 2)
documented that quarterly, HP filtered output correlations between for-
eign countries and the U.S. are higher than HP filtered consumption cor-
relations.
Correlation with U.S.
Country Output Consumption
Australia 0.51 -0.19
Austria 0.38 0.23
Canada 0.76 0.49
France 0.41 0.39
Germany 0.69 0.49
Italy 0.41 0.02
Japan 0.60 0.44
Switzerland 0.42 0.40
UK 0.55 0.42
Europe 0.66 0.51
• If asset markets are complete, then risk sharing implies that country-
specific output shocks (correlations less than 1) should be pooled and
consumption should be highly correlated across countries.

Theory
• Equivalence of Complete Markets and Planner’s Problem implies inter-
national allocation for a one good, stochastic endowment economy must
satisfy
∞
X £ ¤
max∗
t
E0 β t αu(C(ω t )) + (1 − α)u(C ∗ (ω t ))
{C(ω ),C (ω t )}
t=0
s.t.C(ω ) + C (ω ) = Y (ω t ) + Y ∗ (ω t ), ∀ω t
t ∗ t

• FOC imply
β t π(ω t )αu0 (C(ω t )) = μ(ω t ) = β t π(ω t )(1 − α)u0 (C ∗ (ω t )), ∀ω t .

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 ³ ´1/γ
(1−α)
• Levels and CRRA: C ∗ (ω t ) = α C(ω t ), correlation =1.

• Ratios across time imply

u0 (C(ω t+1 )) u0 (C ∗ (ω t+1 ))

=
u0 (C(ω t )) u0 (C ∗ (ω t ))

and with CRRA preferences this implies equal consumption growth rates
implying correlation =1 even if output correlation is less than one.
• This is only a puzzle if you believe that asset markets are complete.

5 Puzzle 5: Persistent Deviations from Purchas-

ing Power Parity and the Price Puzzle
• Corbae and Ouliaris (1988, REStat) could not reject the hypothesis that
deviations from purchasing power parity persist forever.
• Frictionless goods market arbitrage implies that the dollar value of a mar-
ket basket of tradables in the U.S. should equal the dollar value of a market
basket of similar tradables in the foreign country (i.e. Pt = et Pt∗ where Pt
denotes #$/USbasket, Pt∗ denotes #FC/Fbasket, et denotes the nominal
exchange rate (i..e #$/FC)).2
• Alternatively, this implies that the real exchange rate s should be 1 (i.e.
#$
eP ∗ · #F C
#U Sb
1= P = FC
#$
Fb
= Fb (≡ s)).
U Sb

• Test whether PPP deviations are persistent is equivalent to a “unit root”

test on the real exchange rate

st = a + bst−1 + ut

Find that b = 0.99 for G7 pairs using the CPI, could not reject hypothesis
that b = 1 (a unit root) using ADF tests.
• Engel (1999, JPE) documents that persistence holds for baskets of trad-
ables.
• Backus, Kehoe, Kydland (1993, FRBMQR Tables 1&6). Call the high
standard deviation of terms of trade and the high persistence from 1970-
mid 1990 the “price puzzle”.
2 Note that the definition of appreciation and depreciation of exchange rates depends crit-

ically on how the ratio is expressed. If as here et = #$/1f c, then a depreciation of the dollar
corresponds to a rise in e.That is, it takes more $ to get a unit of foreign currency.

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 Country SD Output% SD Terms of Trade% Persistance Terms of Trade
Australia 1.45 5.78 0.82
Austria 1.28 1.73 0.46
Canada 1.50 2.99 0.85
France 0.90 3.52 0.75
Germany 1.51 2.66 0.85
Italy 1.69 3.50 0.78
Japan 1.35 7.24 0.86
Switzerland 1.92 2.85 0.88
UK 1.61 3.14 0.80
US 1.92 3.68 0.83

• O-R argue (p.380) that “Monopoly and nominal rigidities appear to be es-
sential elements of any resolution of the PPP puzzle.” We will see a model
that does just that in the Chari, Kehoe, and McGrattan (2002,RESTUD)
paper.

6 Puzzle 6: Exchange Rate Disconnect

• Baxter and Stockman (1989, JME) study differences in statistical prop-
erties of quarterly, filtered (remove deterministic trend or first difference)
real variables (output, consumption, trade balances, government excpen-
diture) under fixed (1960-70) and flexible (1973-85) exchange rate systems.
• The general result is (p.399) that “The volatility of the real exchange rate
is higher under flexible rates than fixed, but the behavior of real aggregates
such as industrial production and trade flows do not appear to change in
any systematic way as a result of exchange rate regime.”
• Some important facts are:

— volatility (s.d.) of real gdp growth rose only slightly in flexible rate
regime
— no systematic change in volatility of consumption
— increase in correlation between output and consumption
— real exchange volatility has increased significantly (use F-test).
— increased correlation of govt expenditure across countries.

• Some of these facts are also in Backus, Kehoe, Kydland (1993, FRBMQR,
Table 7).

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Country Period Regime SD Terms of Trade% SD Output% SD Net Exports%
Canada 1955-1971 Fixed 1.19 1.38 0.78
1972-1990 Floating 3.05 1.54 0.79
Japan 1955-1971 Fixed 2.29 1.93 1.06
1972-1990 Floating 7.12 1.19 0.92
UK 1955-1971 Fixed 1.45 1.25 0.74
1972-1990 Floating 3.05 1.67 1.22
US 1955-1971 Fixed 1.26 1.23 0.32
1972-1990 Floating 3.79 1.94 0.54

7 Puzzle 7: Forward Premium Puzzle

• Arbitrage and risk neutrality imply that the forward rate should be an
unbiased predictor of future spot rates or

Et et+1 = ft ⇔ et+1 − et = ft − et + ut+1

where ut+1 is mean zero white noise.

• Fama (1984, JME) documents that the forward rate is a biased predictor
of future spot exchange rates for 1975-89 via regressions of the (difference
stationary) form

et+1 − et = a + b(ft − et ) + ut+1 .

• While the null is a = 0, b = 1, Fama finds that b < 0 and significant across
DM,Yen,Pound and a 6= 0. Even with risk aversion, the premium is too
large to be explained by a version of the CCAPM model without resorting
to absurdly high degrees of risk aversion.

8 Puzzle 8: Why are there Twin Deficits in De-

veloping Countries but not Developed Coun-
tries?
• This is one of those IMF type questions. See Backus, et. al. (2005)
• Lawrence Summers (former Treasury secretary). “The most serious prob-
lem we have faced in the last fifty years is that of low national saving,
resulting dependence of foreign capital, and fiscal sustainability. ...The
current account deficit has widened sharply over the last four years.... to
an unprecedented rate of 5% of net national saving. More than 100% of
the deterioration of the current account deficit is accounted for by a drop
in national saving. ... The clear change in national saving ... comes from
the increase in the federal budget deficit...”

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 • Y = C +I +G+N X and S priv = Y −T −C implies N X = S priv +T −G−I
or N X = S −I where national savings S = S priv +S pub and S pub = T −G.
• For the US, the correlation of T − G and N X is 0.15 in Backus, et. al.
• Table 3 of Chinn, M. and E. Prasad (2003) “Medium term determinants
of current accounts in industrial and developing countries: an empirical
exploration”, Journal of International Economics, 59, p. 47-76 provides
the following information. For industrial countries, coefficient of regression
of current account to gdp on budget to gdp (and other variables) with
standard errors *** denotes significant at 1% level:

all all w/o africa industrial developing developing w/o africa

0.306∗∗∗ (0.065) 0.195∗∗∗ (0.059) 0.131 (0.079) close to 10% 0.389∗∗∗ (0.071) 0.259∗∗∗ (0.062)

• The fact that there is no relation between net exports and the government
budget for developed countries is consistent with a model of ricardian
equivalence. That is, if there are increased budget deficits then private
agents save more to pay off future taxes, thereby offsetting the decrease
in public saving.
• The findings for developing countries is consistent with a model where ri-
cardian equivalence doesn’t hold). ↑ G − T =⇒↑ r =⇒↑ e (to buy³ U.S. T- ´
eP f
bills need $ appreciating the nominal exchange rate #f $
c
)=⇒↑ s ≡ P
(if domestic and foreign price levels are sticky)=⇒↑ (Im −Ex) (if foreign
goods are relatively less expensive, we buy more of them and if our goods
are relatively more expensive, foreigners buy less of them - this substitu-
tion may take some time).
• Ricardian equivalence doesn’t tend to hold in models with financial market
imperfections. This seems much more likely in developing economies.

9 Puzzle 9: Why is financial development cor-

related with growth?
Levine (1997, JEL) documents a positive correlation between financial devel-
opment and economic growth, as well as the finding that the level of financial
development is a good predictor of future economic growth.

• Reminded of a brilliant title: Greenwood and Smith (1997, JEDC) “Finan-

cial Markets in Development and the Development of Financial Markets”.
The title suggests the possible endogeneity problems/inability to identify
the direction of causation.
• The following facts for 80 countries over 1960-1989 are from King and
Levine, QJE and JME:

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 • Table 1: There are significant differences in measures of financial develop-
ment for rich vs poor (based on real per capita GDP) countries.

RGDP85 vs Fin Meas

Fin Measure Very Rich Rich Poor Very Poor
Depth 0.67 0.51 0.39 0.26
Bank 0.91 0.73 0.57 0.52
Priv 0.71 0.58 0.47 0.37
PrivY 0.53 0.31 0.20 0.13
Obs 29 29 29 29

where Depth=Liquid Liabilities (currency+demand deposits+savings de-

posits+mmmfs)/GDP; Bank=Commercial Bank Credit/(Comm. Bank credit+Central
Bank domestic credit (Tbills +CommBReserves)); Priv=credit allocated to pri-
vate firms/total domestic credit;PrivY=credit to priv firms/GDP.

• — Table 1 shows:
— ∗ citizens of richest countries hold about 2/3 of a year’s income in
liquid assets while citizends of the poorest countries hold about
1/4 of a year’s income in liquid.
∗ commercial banks in rich countries allocate more credit while
Central Banks allocate more credit in poor countries.
• Table 2: There is a strong, significant positive relationship between mea-
sures of long run (averaged over 1960-1989) growth Gi and the long-run
level of financial development Fi for 77 countries in regressions of the form:

Gi = a + bFi + cX + ui

where X are other explanatory variables like initial per capita income,
avg schooling, etc. The table gives b and its p-value. All are significant at
least at the 5% level.

Growth and Fin. Meas

variable Gi Depth Bank Priv PrivY
RGDPGrowthpc 0.024 (0.007) 0.032 (0.005) 0.034 (0.002) 0.032 (0.002)
RKGrowthpc 0.022 (0.001) 0.022 (0.012) 0.020 (0.011) 0.025 (0.001)
TFPGrowth 0.018 (0.026) 0.026 (0.010) 0.027 (0.003) 0.025 (0.006)

• Table 3: There is a strong, significant positive relationship between mea-

sures of long run growth Gi and initial (1960) Depth Fi1960 for 77 countries
in regressions of the form:

Gi = a + bFi1960 + cX + dG1960
i + ui

where X are other explanatory variables like avg schooling, etc. The table
gives b and its p-value. All are significant at least at the 5% level.

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 Growth and Initial Depth
variable Gi Depth
RGDPGrowthpc 0.028 (0.001)
RKGrowthpc 0.019 (0.001)
TFPGrowth 0.022 (0.001)

This is suggestive of some sort of causation result.

• The findings for TFP are pretty interesting since we typically take (at
least in RBC models) TFP as exogenous.

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