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Equilibrium Portfolios and External Adjustment under Incomplete Markets

  • Roberto Rigobon


  • Anna Pavlova


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 it admits an exact closed-form solution regardless of whether financial markets are complete or incomplete. We derive a necessary and sufficient condition under which the current account is different from zero and shed light on the relationship between market incompleteness and the current account dynamics. Furthermore, 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. We demonstrate how countries’ portfolio compositions affect the dynamics of their external accounts and argue that a description of the international adjustment mechanism is incomplete if it does not encompass portfolio choice.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1349.

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Date of creation: 2011
Date of revision:
Handle: RePEc:red:sed011:1349
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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