We show that a flex-price two-sector open economy DSGE model can explain the poor degree of international risk sharing and exchange rate disconnect. We use a suite of model evaluation measures and examine the role of (1) traded and non-traded sectors; (2) financial market incompleteness; (3) preference shocks; (4) deviations from UIP condition for the exchange rates; and (5) creditor status in net foreign assets. We find that there is a good case for both traded and non-traded productivity shocks as well as UIP deviations in explaining the puzzles.
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- current account dynamics
- real exchange rates
- financial frictions
- incomplete markets