Productivity Shocks, Stabilization Policies and the Dynamics of Net Foreign Assets

In this paper we investigate the role of macroeconomic stabilization policies for the international transmission of productivity shocks and their e ects on the external sector. We develop a two-country stochastic Dynamic New-Keynesian \perpetual youth" model of the business cycle with incomplete international nancial markets. Our OLG structure implies stationary net foreign asset dynamics and allows for a thorough analysis of the interaction of monetary policy with non-balanced budget scal policy. We derive the dynamic and cyclical properties of scal de cit feedback rules and their implications for net foreign assets dynamics. Our results imply that the degree of \ scal discipline", i.e. the extent to which the scal rule responds to debt dynamics, is crucial for the dynamics of net foreign assets. We show that under a counter-cyclical scal rule with low scal discipline temporary positive productivity shocks may result in substantial deteriorations of the Net Foreign Asset position in the medium run. This result crucially hinges on the interplay among nominal rigidities, non-balanced budget scal policy, and the wealth e ects on consumption that are implied by our OLG structure.