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An Asset-Pricing View of External Adjustment

  • Anna Pavlova
  • Roberto Rigobon

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 admits a closed-form solution regardless of whether financial markets are complete or incomplete. We find that the excessive emphasis put in the literature on solving models with incomplete markets for the sole purpose of obtaining nontrivial implications for the current account is misplaced. We revisit the current debate on the relative importance of the standard vs. the capital-gains-based (or "valuation'') channels of the external adjustment and establish that in our framework they are congruent. Our model's implications are consistent with a number of intriguing stylized facts documented in the recent empirical literature.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13468.

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Date of creation: Oct 2007
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Publication status: published as Pavlova, Anna & Rigobon, Roberto, 2010. "An asset-pricing view of external adjustment," Journal of International Economics, Elsevier, vol. 80(1), pages 144-156, January.
Handle: RePEc:nbr:nberwo:13468
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