Working Paper: NBER ID: w13468
Authors: Anna Pavlova; Roberto Rigobon
Abstract: Recent evidence on the importance of cross-border equity flows calls for a rethinking of the standard theory of external adjustment. We introduce equity holdings and portfolio choice into an otherwise conventional open-economy dynamic equilibrium model. Our model is simple and admits a closed-form solution regardless of whether financial markets are complete or incomplete. We find that the excessive emphasis put in the literature on solving models with incomplete markets for the sole purpose of obtaining nontrivial implications for the current account is misplaced. We revisit the current debate on the relative importance of the standard vs. the capital-gains-based (or "valuation'') channels of the external adjustment and establish that in our framework they are congruent. Our model's implications are consistent with a number of intriguing stylized facts documented in the recent empirical literature.
Keywords: external adjustment; capital gains; portfolio choice; current account
JEL Codes: F31; F36; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| portfolio structure (G11) | current account imbalances (F32) |
| hedging demands (R21) | portfolio choices (G11) |
| changes in asset returns (G19) | discount factor (H43) |
| discount factor (H43) | future trade surpluses (F10) |
| capital gains adjusted current account (F32) | traditional current account (F32) |
| widening current account deficit in the US (F32) | normal adjustment process (C62) |