TY - JOUR AU - Hassan, Tarek Alexander AU - Mertens, Thomas AU - Zhang, Tony TI - Not so Disconnected: Exchange Rates and the Capital Stock JF - National Bureau of Economic Research Working Paper Series VL - No. 21445 PY - 2015 Y2 - August 2015 DO - 10.3386/w21445 UR - http://www.nber.org/papers/w21445 L1 - http://www.nber.org/papers/w21445.pdf N1 - Author contact info: Tarek Alexander Hassan Department of Economics Boston University 270 Bay State Road Boston, MA 02215 Tel: 773/834-3291 Fax: 773/753-0851 E-Mail: thassan@bu.edu Thomas Mertens Federal Reserve Bank of San Francisco Economic Research - Finance 101 Market Street, Mail stop 1130 San Francisco, CA 94105 Tel: (415) 977-3868 E-Mail: thomas.mertens@sf.frb.org Tony Zhang Federal Reserve Board 20th Street and Constitution Avenue N.W. Washington, DC 20551 E-Mail: tony.zhang@frb.gov M1 - published as Tarek A. Hassan, Thomas M. Mertens, Tony Zhang. "Not So Disconnected: Exchange Rates and the Capital Stock," in Michael B. Devereux, Francesco Giavazzi, and Kenneth D. West, editors, "NBER International Seminar on Macroeconomics 2015" Journal of International Economics (Elsevier), Volume 99, Supplement 1 (2016) AB - We investigate the link between stochastic properties of exchange rates and differences in capital-output ratios across industrialized countries. To this end, we endogenize capital accumulation within a standard model of exchange rate determination with nontraded goods. The model predicts that currencies of countries that are more systemic for the world economy (countries that face particularly volatile shocks or account for a large share of world GDP) appreciate when the price of traded goods in word markets is high. These currencies are better hedges against consumption risk faced by international investors because they appreciate in "bad" states of the world. As a consequence, more systemic countries face a lower cost of capital and accumulate more capital per worker. We estimate our model using data from seven industrialized countries with freely floating exchange rate regimes between 1984-2010 and show that cross-country variation in the stochastic properties of exchange rates accounts for 72% of the cross-country variation in capital-output ratios. In this sense, the stochastic properties of exchange rates map to fundamentals in the way predicted by the model. ER -