An Asset Pricing View of the Current Account (FEPAV)

FEPAV is a study contract with the Banque de France (11th call for projects), led by Anna Pavlova (London Business School) with Roberto Rigobon (Sloan School of Management, MIT).

The current literature on global imbalances has produced very important new insights. The relationship between changes in asset prices, portfolio choices, and the current account, however, has to be studied in a framework that is able to encompass all these ingredients at the same time. Our goal is to provide such a framework: simple enough to be extended to include financial inefficiencies, multiple countries, productivity and demand shocks, and at the same time general enough to be able to capture all the close relationships that exist between the current account and asset prices. In other words, our project offers an asset pricing view of the current account.

We propose to study how the current account of a country is affected by capital gains on the country's net foreign asset position. Our goal is twofold. First, we would like to contribute to the literature on global imbalances by providing a fully-fledged dynamic general equilibrium model in which we can fully characterize the countries' optimal portfolios of assets and identify capital gains on these portfolios and their dynamics. We plan to calibrate our model to quantify the magnitudes of global imbalances using a measure of the current account that adjusts the textbook measures so as to incorporate capital gains on net foreign asset positions of countries. We expect that theoretical predictions derived from the model would give a range of practical implications: some consistent with stylized facts about the current account and some genuinely new that subsequent empirical and policy work may explore. Second, more generally, we intend to argue that there exists a close relationship between a country's current accounts and returns on financial assets at home and abroad, and hence any model of an external adjustment mechanism would be incomplete if it ignores optimal portfolio choice and determination of financial markets prices.