Working Paper: NBER ID: w11440
Authors: Anna Pavlova; Roberto Rigobon
Abstract: This paper examines the co-movement among stock market prices and exchange rates within a three-country Center-Periphery dynamic equilibrium model in which agents in the Center country face portfolio constraints. In our model, international transmission occurs through the terms of trade, through the common discount factor for cash flows, and, finally, through an additional channel reflecting the tightness of the portfolio constraints. Portfolio constraints are shown to \ngenerate endogenous wealth transfers to or from the Periphery countries. These implicit transfers are responsible for creating contagion among the terms of trade of the Periphery countries, as well as their stock market prices. Under a portfolio constraint limiting investment of the Center country in the stock markets of the Periphery, stock prices also exhibit a flight to quality: a negative shock to one of the Periphery countries depresses stock prices throughout the Periphery, \nwhile boosting the stock market in the Center.
Keywords: Wealth Transfers; Contagion; Portfolio Constraints
JEL Codes: G12; G15; F31; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Portfolio constraints in the center country (G15) | Wealth transfers to periphery countries (F16) |
| Wealth transfers to periphery countries (F16) | Terms of trade (F14) |
| Terms of trade (F14) | Stock prices of periphery countries (F31) |
| Tightening of portfolio constraints (G11) | Flight to quality (L15) |
| Negative shock to periphery country (F65) | Decrease in stock prices of periphery country (F65) |
| Negative shock to periphery country (F65) | Increase in stock prices of center country (F31) |
| Wealth transfers (D31) | Contagion effects among periphery countries' stock markets (F65) |
| Contagion effects among periphery countries' stock markets (F65) | Increased comovement of asset prices (G19) |