《external wealth》.pdf

European Economic Review 46 (2002) 1049–1071 /locate/econbase External wealth, the trade balance, and the real exchange rate Philip R. Lanea; c; ∗, Gian Maria Milesi-Ferrettib; c a Institute for International Integration Studies, Trinity College Dublin, Dublin, Ireland b International Monetary Fund, Washington, DC, USA c CEPR, London, U Abstract We examine the link between the net foreign asset position, the trade balance and the real exchange rate. In particular, we decompose the impact of a country’s net foreign asset position (‘external wealth’) on its long-run real exchange rate into two mechanisms: the relation between external wealt hand the trade balance; and, holding xed other determinants, a negative relation between the trade balance and the real exchange rate. We also provide additional evidence that the relative price of nontradables is an important channel linking the trade balance and the real c exchange rate. 2002 Elsevier Science B.V. All rights reserved. JEL classication: F21; F31; F41 Keywords: Net foreign assets; Trade balance; Real exchange rate 1. Introduction The rapid growt hin the net external liabilities of the US and its implications for a possible reversal in the current strengt hof the dollar are a dominant theme of discussion in economic policy circles. This theme is certainly not new: the debate on the relation between international payments and real exchange rates has a long and distinguished intellectual history, and was at the forefront in the late 19