equilibrium portfolios and external adjustment under.pdf

Equilibrium Portfolios and External Adjustment under Incomplete Markets∗ Anna Pavlova Roberto Rigobon London Business School Sloan School of Management, MIT and CEPR and NBER This draft: July 2, 2008 Abstract 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. JEL Classifications: G12, G15, F31, F36 Keywords: Current account, portfolio rebalancing, capital gains, international finance, asset pric- ing, global imbalances. ∗Correspondence to: Roberto Rigobon, Sloan School of Management, MIT, 50 Memorial Drive, E52-431, Cam- bridge, MA 02142-1347, ri