Backus–Smith Puzzle and the European Union: It's Not Just the Nominal Exchange Rate

Abstract

The goal of our research is testing of presence and background examination of Backus–Smith puzzle in the EU. The research is based on the technique of econometric analysis of panel data, i.e. on the estimation of one-way/two-way error component models and models without effects. The results of the research have shown that: (a) there is serious evidence on presence of the Backus–Smith puzzle in the EU, (b) its background comprises both nominal exchange rate and inflation differential, and (c) empirical data rejects complete risk sharing assumption strongly and decisively, but this does not explain the Backus–Smith puzzle. The basic conclusion of our research is that nominal exchange rate movements are not the only source of Backus–Smith puzzle in the EU, as is the case in OECD members states.