Equilibrium Portfolios and External Adjustment Under Incomplete Markets

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 it admits an exact closed-form solution regardless of whether financial markets are complete or incomplete. In this simple framework, we are able to establish interconnections between the real side of the economy, represented by the trade balance, the current account, and consumption allocations and the financial side, such as portfolio holdings, stock prices and valuation changes. Methodologically, we contribute to the existing DSGE literature on international portfolio choice that so far has either relied on approximation methods or used simplified asset market structures.

Number of Pages in PDF File: 41

Keywords: Current account, portfolio rebalancing, capital gains, international finance, asset pricing, global imbalances

JEL Classification: G12, G15, F31, F36

working papers series