Two of the main puzzles in international economics are the consumption and the portfolio home biases. They are empirically related: countries that are more open to trade also have more internationally diversified portfolios. In a two-country stochastic equilibrium model, I prove that introducing trade costs in goods market alone, as suggested by Obstfeld and Rogoff [2000], is not sufficient to explain these two puzzles simultaneously. On the contrary, for reasonable parameter values, trade costs create a foreign bias in portfolios. To reconcile facts and theory, I introduce a combination of small frictions in financial markets and trade costs in goods market. The interaction between the two types of frictions determines optimal portfolio allocation. When trade costs increase, competition in the goods market softens and the volatility of domestic income falls. Facing lower risk, investors have less incentive to pay the financial transaction cost and increase their holdings of domestic assets. The model correctly predicts that the larger the home bias in consumption, the larger the home bias in portfolios.
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Paper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number
DR 06011.
Find related papers by JEL classification: F30 - International Economics - - International Finance - - - General F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
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Philip R. Lane & Gian Maria Milesi-Ferretti, 2007.
"Europe and global imbalances,"
Economic Policy,
CEPR, CES, MSH, vol. 22, pages 519-573, 07.
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