Transport Cost, Relative Price, and International Risk Sharing

Abstract

This paper examines the role Of transport cost in accounting for the puzzling behaviors of relative price and risk sharing across countries. We show that introducing transport cost to an otherwise standard competitive model improves its ability to rationalize deviations from the law of one price and imp effect international risk sharing. Our analysis suggests that the purchasing power parity and international consumption correlation puzzles can naturally arise in the presence of real frictions, even under the assumption of complete financial markets.