International risk sharing and incomplete asset market

Why international risk sharing is less efficient than intranational consumption risk sharing has been one of the central questions of international economics literature. Classic tests of international risk sharing have focused on predictions with respect to aggregate consumption across countries. In an economy where the law of one price does not hold, the growth rate of relative consumption should be negatively correlated with growth rate of relative aggregate price, which means that the country with a higher growth rate in consumption should experience a relatively lower growth rate in aggregate price. However, the evidence goes exactly the other way. This data pattern has emerged as one of the major puzzles in international macroeconomics literature and has been called "Backus-Smith Puzzle" or "Consumption and Real Exchange Rate Anomaly."; In this dissertation, we study an economy where asset market incompleteness is endogenously generated. The key empirical puzzling regularity on relative consumption and price arises as an outcome of limited risk sharing caused by this incompleteness of asset market.; In the first chapter, we address the issue of international risk sharing in the standard asset pricing framework. We distinguish the risk sharing conditions from the different equilibrium conditions with incomplete asset market and find that incompleteness of asset markets drives a wedge between real exchange rates and the relative consumption.; In the second chapter, we study an economy without commitment. In this economy the bilateral risk sharing contract is not fully enforceable. To provide an appropriate incentive of commitment, the nature of the risk sharing contracts is limited and the amount of assets that one can trade in the asset market is endogenously restricted.; In the third chapter, we study an economy with private information. In this economy, the adverse incentives caused by informational asymmetries in bilateral risk sharing contracts can prevent efficient risk sharing across countries. The seemingly perverse negative correlation forms a necessary part of the optimal solution to the moral hazard problem.