Risk Sharing and Real Exchange Rate : The Roles of Non-tradable Sector and Trend Shocks

In this paper, we show that tradable and non-tradable TFP processes of the US and Europe have unit roots and can be modeled by a vector error correction model (VECM). Then, we develop a standard two country and two good (tradable and non-tradable) DSGE model. Our model implies that using cointegrated TFP processes improves the real exchange rate (RER) volatility and risk sharing puzzles compared to the model with transitory TFP processes. Cointegrated TFP shocks, or trend shocks, generate signi?cant income e¤ects, and amplify the mechanisms that produce high RER volatility. Moreover, trend shocks break the tight link between relative consumption and RER for low and high values of trade elasticity parameters.