Essays on international consumption risk sharing in the presence of incomplete markets and heterogeneous preferences

When agents across countries have different consumption baskets in a world of incomplete markets, country-specific output shocks make the cost of living of agents across countries different, changing relative consumption. This redistribution of purchasing power across countries is not diversifiable through financial transactions. Flexible exchange rates may work as consumption insurance by reducing the change in real exchange rates if the elasticity of money demand is greater than unity. The empirical work on the quarterly bilateral data of 12 trading partners of the US showed mean growth rates of spot exchange rates moved in the opposite direction of mean growth rates of relative output during the period from 1986:3 to 2002:4.; Even in a world of incomplete markets, if agents have a logarithmic utility or if they have identical isoelastic preferences when goods' prices are predetermined, agents' portfolio choice or investment decision are separable from their consumption decision so that capital moves to equalize expected returns of identical assets in different denomination. Agents with a logarithmic utility choose their optimal portfolio by expected profit maximization while identical agents with relative risk aversion greater than unity by mean variance optimization. The optimal portfolio compositions become identical across agents. Savings' allocations in the world become efficient. For the US, Canada, Germany, Japan and the UK, the share of each foreign asset in total foreign assets appear to be strongly positively correlated with the share of each import in total imports.; Trade balance has an influence on the determination of the interest rate differential and the spot exchange rate in the short run when aggregate prices are sluggish. These influences are effective through agents' portfolio choices. Home country's trade surplus is net purchase of assets in foreign denomination in the balance of payment. The increase in the supply of assets in foreign currency denomination shifts risk premium onto assets in home currency denomination because home currency is more likely to appreciate. This expectation is fulfilled when the decrease in relative home interest rate appreciates the home currency in the foreign exchange market. For the bilateral data of the US and its 12 trading partners, these effects appeared to be positive between trade balances and ex ante returns and to be negative between trade balances and spot exchange rates for the period from 1987:2 through 1998:4.