Backus–Kehoe–Kydland Puzzle

Published Mar 22, 2024

Definition of the Backus–Kehoe–Kydland (BKK) Puzzle

The Backus–Kehoe–Kydland (BKK) puzzle, named after economists David Backus, Finn E. Kydland, and Patrick J. Kehoe, refers to an economic anomaly observed in international finance and macroeconomics. The puzzle arises from the empirical observation that contrary to theoretical predictions, real exchange rates are more volatile than consumption ratios across countries. Furthermore, consumption is less correlated across countries than what is suggested by models assuming perfect capital markets and international risk sharing.

Understanding the BKK Puzzle

To delve into the Backus–Kehoe–Kydland puzzle, one must first understand the basics of international finance theory, which predicts that when capital markets are open and integrated, investors and consumers can share risks globally. This risk-sharing mechanism should, in theory, lead to high correlations in consumption growth rates across countries because individuals can smooth out country-specific economic shocks by diversifying their investment portfolios internationally. Additionally, the volatility of real exchange rates should be moderated by the commonality of consumption paths.

However, empirical evidence suggests the opposite: real exchange rates exhibit high volatility, and cross-country consumption correlations are lower than expected. This discrepancy between theoretical predictions and real-world observations constitutes the BKK puzzle.

Significance of the BKK Puzzle

The importance of the Backus–Kehoe–Kydland puzzle extends beyond its academic intrigue; it challenges the foundational assumptions of international macroeconomic models. By highlighting the failures of current models to accurately predict consumption and exchange rate behaviors, the BKK puzzle prompts economists to rethink the assumptions about market completeness, frictionless markets, and perfect international risk sharing.

Investigating the puzzle has led to the development of alternative models that incorporate factors such as goods market frictions, financial market imperfections, and non-tradable goods. These models attempt to better explain the observed phenomena by relaxing the stringent assumptions of earlier theories, suggesting that real-world markets are far from perfectly efficient and integrated.

Frequently Asked Questions (FAQ)

Why are real exchange rates and consumption correlations important in international economics?

Real exchange rates and consumption correlations are critical indicators of international economic integration and the effectiveness of international risk-sharing mechanisms. High consumption correlations suggest that countries can efficiently share economic risks, leading to better outcomes for global economic stability. Meanwhile, the volatility of real exchange rates impacts international trade, investments, and economic policy planning.

How has the BKK puzzle impacted economic theory and policy?

The BKK puzzle has significantly influenced economic theory by challenging conventional wisdom about international risk sharing and market integration. It has led to the development of new models that consider imperfections in international financial markets, non-tradable goods, and transaction costs. In terms of policy, it suggests that policymakers need to consider these market imperfections when designing policies aimed at enhancing international economic integration and stability.

Can technology and globalization resolve the BKK puzzle?

Technology and globalization have the potential to impact the BKK puzzle by making markets more integrated and reducing barriers to international capital flows. Increased digital connectivity and the rise of fintech could facilitate better international risk sharing. However, whether these trends will fully resolve the puzzle remains an open question, as non-financial barriers, regulatory differences, and cultural factors continue to influence economic behaviors.

In conclusion, the Backus–Kehoe–Kydland puzzle represents a fascinating challenge in the field of international economics, prompting ongoing research and debate. It underscores the complexity of global financial markets and the importance of developing more nuanced economic theories and policies that reflect the intricate realities of international risk sharing and market behaviors.