Exchange rate dynamics and consumption of traded goods

Abstract

A Constant Elasticity of Substitution (CES) aggregator of domestic and foreign goods is assumed in virtually any model of international macroeconomics with multiple traded goods. If baskets of traded goods are allocated optimally across countries, the CES aggregator links trade flows to exchange rate dynamics implying a condition for optimal allocation of individual traded goods across countries. The condition holds irrespectively of assumptions about preferences or endowment processes. This paper analyzes optimal allocation of traded goods empirically for 9 OECD countries and finds that it is mostly rejected by data. The finding casts doubts on the ability of international macroeconomic models to jointly explain dynamics of consumption and exchange rates.