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An asset-pricing view of external adjustment

  • Pavlova, Anna
  • Rigobon, Roberto

Recent literature has argued that conventional measures of external sustainability - the trade balance and current account - are misleading because they omit capital gains on net foreign asset positions. We adjust the definition of the current account to include the capital gains and discuss how this may affect our thinking about external adjustment and sustainability. We do so in the context of a two-country macro-finance model of Pavlova and Rigobon (2008a) that allows exploration of the interconnections between equilibrium portfolios and external accounts' dynamics. We calibrate the model and find that it generates several testable implications, some of which have already been validated empirically. First, we establish dynamic properties of the capital-gains adjusted current account and show that they are fundamentally different from those of the conventional current account. Second, we find that capital gains have a stabilizing effect on the trade balance and the current account. Finally, we demonstrate that in response to a shock, the conventional and the capital-gains adjusted current accounts may move in opposite directions.

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Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 80 (2010)
Issue (Month): 1 (January)
Pages: 144-156

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Handle: RePEc:eee:inecon:v:80:y:2010:i:1:p:144-156
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