Nicolas Coeurdacier () (Paris-Jourdan Sciences Economiques public)
Abstract
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 diversifed 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 suffcient 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 Society for Economic Dynamics in its series 2006 Meeting Papers with number
111.
Length: Date of creation: 03 Dec 2006 Date of revision: Handle: RePEc:red:sed006:111
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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
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Philip R. Lane & Gian Maria Milesi-Ferretti, 2007.
"Europe and global imbalances,"
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