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The Risk Premium and Long-Run Global Imbalances

  • YiLi Chien
  • Kanda Naknoi

Our paper investigates whether the valuation effect caused by a large risk premium and a low risk-free rate can help to explain the enormous US current account and trade deficit observed in the past decade. To answer this question, we set up an endowment growth model in which investors are endowed with heterogeneous trading technologies. In our model, the average US investors load up more aggregate risk by investing in a risky asset abroad and issuing a risk-free asset. Thanks to the large risk premium as well as the low risk-free rate, the US can sustain a long-run trade deficit even as a debtor country. Quantitatively, we find that the valuation effect caused solely by the high risk premium and the low risk-free rate in our model, which is calibrated to match the external assets and liabilities of US economy, can account for more than half of the observed trade deficit and current account deficit. Our results suggest that the current US trade deficit might not necessarily lead to net export increases or dollar depreciation in the future.

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Paper provided by Purdue University, Department of Economics in its series Purdue University Economics Working Papers with number 1266.

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Length: 51 pages
Date of creation: Oct 2011
Date of revision:
Handle: RePEc:pur:prukra:1266
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