We measure income uncertainty at the level of U.S. states, and the extent to which it has been reduced through risksharing, using a method recently developed by Athanasoulis and van Wincoop (2000). Risk is measured as the standard deviation of state-specific income growth uncertainty, measured by using the error term of a regression of income growth on variables in the information set. Risk sharing is measured by the extent to which this standard deviation has been reduced through financial markets and federal fiscal policy. The advantage of this measure over the existing risk sharing literature is that the interpretation does not depend on many auxiliary assumptions. Our findings on the extent of risk sharing are insensitive to the only assumption we need to make, the variables that are in the information set. We find that the standard deviation of state-specific income growth uncertainty is reduced by less than half through financial markets and federal fiscal policy. We show that the extent of risk sharing would be much higher if agents held better diversified portfolios across the states.

This paper surveys the measurement of trade costs: what we know and don't know but may usefully attempt to learn. Partial and incomplete data on direct measures of costs go with inference on implicit costs from trade flows and prices. Total trade costs in rich countries are large. The ad valorem tax equivalent is about 170 percent when pushing the data hard. Poor countries face even higher trade costs. There is a lot of variation across countries and across goods within countries, much of which makes economic sense. In our survey, theory provides interpretation and perspective and suggests improvements for the future. Some new results are presented to properly apply and interpret gravity theory and handle aggregation.

A major puzzle in international finance is that high interest rate currencies tend to appreciate (forward discount puzzle). Motivated by the fact that only a small fraction of foreign currency holdings is actively managed, we calibrate a two-country model in which agents make infrequent portfolio decisions. We show that the model can account for the forward discount puzzle. It can also account for several related empirical phenomena, including that of “delayed overshooting.” We also show that making infrequent portfolio decisions is optimal as the welfare gain from active currency management is smaller than the corresponding fees. (JEL F31, G11, G15)

Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk (RW) while at the same time exchange rate changes are predictable by interest rate di¤erentials. The RW hypothesis received strong support from the work of Richard A. Meese and Kenneth Rogo ¤ (1983) who were the …rst to show that macro models of exchange rate determination could not beat the RW in predicting exchange rates. On the other hand, Eugene F. Fama (1984) showed that high interest rate currencies tend to subsequently appreciate. This is known as the forward discount puzzle and stands in contrast to Uncovered Interest Parity (UIP), which says that a positive interest di¤erential should lead to an expected depreciation of equal magnitude. The RW hypothesis and the forward discount puzzle are not as contradictory as it seems since the predictability of exchange rate changes by interest di¤erentials is limited. For example, Fama (1984) reports an average R2 of 0.01 when regressing monthly exchange rate changes on beginning-of-period interest di¤erentials. Instead of opposing these two features of the data, in this paper we investigate whether in fact they may be related to each other.

Empirical evidence shows that most exchange rate volatility at short to medium horizons is related to order flow and not to macroeconomic variables. We introduce symmetric information dispersion about future macroeconomic fundamentals in a dynamic rational expectations model in order to explain these stylized facts. Consistent with the evidence, the model implies that (a) observed fundamentals account for little of exchange rate volatility in the short to medium run, (b) over long horizons, the exchange rate is closely related to observed fundamentals, (c) exchange rate changes are a weak predictor of future fundamentals, and (d) the exchange rate is closely related to order flow.

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and some variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account deficit, while its previous strength was explained mainly by growth differentials. In this paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable affects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.

This paper develops a simple general-equilibrium framework to study the effect of the exchange-rate system on trade and welfare. An important feature of the model is deviations from purchasing-power parity, caused by rigid price setting in buyers' currency. In a benchmark model with separable preferences and only monetary shocks, trade is unaffected by the exchange-rate system, consistent with most evidence. In general, both trade and welfare can be higher under either exchange-rate system, depending on preferences and on the monetary-policy rules followed under each system. There is no one-to-one relationship between the levels of trade and welfare across exchange-rate systems. (JEL F31, F33, F41)

Gravity equations have been widely used to infer trade flow effects of various institutional arrangements. We show that estimated gravity equations do not have a theoretical foundation. This implies both that estimation suffers from omitted variables bias and that comparative statics analysis is unfounded. We develop a method that (i) consistently and efficiently estimates a theoretical gravity equation and (ii) correctly calculates the comparative statics of trade frictions. We apply the method to solve the famous McCallum border puzzle. Applying our method, we find that national borders reduce trade between industrialized countries by moderate amounts of 20–50 percent.

National Money as a Barrier to International Trade: The Real Case for Currency Union by Andrew K. Rose and Eric van Wincoop. Published in volume 91, issue 2, pages 386-390 of American Economic Review, May 2001

Using data on international equity portfolio allocations by U.S. mutual funds, we estimate a portfolio expression derived from a standard mean-variance portfolio model extended with portfolio frictions. The optimal portfolio depends on the previous month and the buy-and-hold portfolio shares, and a present discounted value of expected excess returns. We estimate expected return differentials and use them in the portfolio regressions. The estimates imply significant portfolio frictions and a modest rate of risk aversion. While mutual fund portfolios significantly respond to expected returns, portfolio frictions lead to a weaker and a more gradual portfolio response to changes in expected returns. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.