Open economy macroeconomic models typically represent international financial linkages in terms of net foreign assets and the current account. Recent data show, however, that there are large cross-country gross asset and liability positions. Lane and Milesi-Ferretti (2001,2006) show that these gross portfolio holdings have grown rapidly, particularly in the last decade. The existence of large gross positions offers a number of interesting challenges for open economy macro theory. For instance, can international macroeconomic models offer any explanation for the observed structure of portfolio holdings?
What are the important macroeconomic determinants of the size and composition of gross portfolio positions? The importance of gross asset positions, however, goes beyond questions about the determinants of portfolio choice. This is because gross asset and liability positions can themselves have important effects on macroeconomic dynamics. For instance a change in the nominal exchange rate ora change inequity prices can give rise to capital gains and losses for gross positions which can have very large effects on the value of net foreign assets.
While these issues are obviously of interest to open economy macroeconomists and policymakers, current theoretical models and current solution methods cannot be used to analyse the implications of gross portfolio holdings in any very systematic way. This is because it is difficult to solve portfolio choice problems within standard general equilibrium macroeconomic models with complex asset markets.
One approach that has recently been adopted is to focus on complete markets structures. Engel and Matsumoto (2005) and Kollmann (2006) represent examples of such an approach. In the case of complete markets, it is possible to solve for a macroeconomic equilibrium without having first to solve for be haviour in asset markets.It is then possible to derive and analyse the implied country portfolios which support the macroeconomic equilibrium.
Download
Solving for Country Portfolios in Open Economy Macro Models
