Working Paper: NBER ID: w13483
Authors: Jonathan Heathcote; Fabrizio Perri
Abstract: In simple one-good international macro models, the presence of non-diversifiable labor income risk means that country portfoliosshould be heavily biased toward foreign assets. The fact that theopposite pattern of diversification is observed empirically constitutes the international diversification puzzle. We embed aportfolio choice decision in a frictionless two-country, two-good version of the stochastic growth model. In this environment, which is a workhorse for international business cycle research, we derive a closed-form expression for equilibrium country portfolios. These are biased towards domestic assets, as in the data. Home bias arises because endogenous international relative price fluctuations make domestic stocks a good hedge against non-diversifiable labor income risk. We then use our our theory to link openness to trade to the level of diversification, and find that it offers a quantitatively compelling account for the patterns of international diversification observed across developed economies in recent years.
Keywords: international diversification; portfolio choice; home bias; trade openness
JEL Codes: F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| home bias in international portfolios (G15) | domestic stocks serve as effective hedges against non-diversifiable labor income risk (J49) |
| fluctuations in international relative prices (F31) | home bias in international portfolios (G15) |
| trade openness (F43) | variations in international diversification (F29) |
| relative preferences for domestic versus foreign goods (D11) | home bias in international portfolios (G15) |
| capital share in production (D33) | relative preferences for domestic versus foreign goods (D11) |