composition of foreign assets: the valuation-e ﬀect …economics.ca/2007/papers/0585.pdf ·...

Composition of Foreign Assets: The

Valuation-Effect and Monetary Policy

Mathias Hoffmann∗ and Caroline Schmidt†

January 31st 2007

Abstract

Over the last two decades, the globalization of financial markets has become

an important feature of the world economy. A remarkable characteristic of the in-

creased gross capital positions observed is that for many industrialized economies,

most of the liabilities are denominated in the countries’ own currency while their

assets are mainly held in foreign currencies. Consequently, a depreciation of their

currency boosts the domestic currency value of their asset position relative to the

currency value of their liabilities, improving the net foreign asset position of the

country. However, valuation effects may also be due to other price changes, e.g.

changes in asset prices or the value of FDI. Besides the impact on the value of as-

sets and liabilities, an exchange rate change induced by monetary policy will also

alter the domestic currency returns on foreign assets. Yet, the latter may as well

be affected by variations in the underlying returns. The contribution of this paper

is to account for the variety of implications due to increased financial integration

by allowing for all three possible international linkages — trade in bonds and eq-

uities across countries as well as FDI — jointly. In a two-country DSGE model

∗University of Cologne, Department of Economics, Albertus-Magnus-Platz, 50931 Cologne, Ger-many, [email protected]

†Caroline Schmidt, Konjunkturforschungsstelle der ETH Zürich, ETH Zentrum WEH,CH-8092 Zürich, Switzerland, Phone: ++41-44-632-6899, Fax: ++41-44-632-1218, E-mail:[email protected].

1

with sticky prices and alternative positive international investment positions in

the steady state, we show that the wealth-enhancing redistributional effect of a

depreciation in response to a monetary expansion faces a counter weight when

FDI is incorporated. With FDI, foreign households can participate in the boom

in demand for home goods as returns on capital in the home country increase.

Thus, in such a situation a depreciation of the currency is no longer necessarily

welfare-improving for the home economy.

2

1 Introduction

Over the last two decades the globalization of financial markets has become an important

feature of the world economy. The associated surge in the mobility of international cap-

ital has become increasingly important for industrialized and industrializing economies.

IMF data indicate that gross capital flows between industrial countries rose by up to

300 percent compared to trade flows, which only increased by 63 percent. The increase

in gross capital flows is accompanied by a greater interdependence between national

economies. For example, US ownership of foreign portfolio equity assets and bonds was

below 1 percent of GDP in the beginning of the 1980s. In 2003 the ownership in for-

eign equity holdings (defined as foreign direct investment (FDI) plus portfolio equity)

increased to 42 percent of GDP. For other countries, for example the Netherlands, for-

eign equity holdings account for more than 150 percent of GDP. For Switzerland, gross

foreign assets even amount to almost 500 percent of GDP. On the other hand, the main

OECD countries’ foreign equity liabilities on average account for 60 percent of their

respective GDP.1

A remarkable feature of the increased gross capital flows is that for most industri-

alized economies, most of the liability positions are denominated in the countries’ own

currency while their asset holdings are mainly in foreign currencies. Consequently, a

depreciation of their currency boosts the domestic currency value of their asset position

relative to the currency value of their liabilities, improving the net foreign asset position

of the country. This valuation effect is generated by movements in the nominal exchange

rate. As a result, external imbalances — for example the historically high current account

deficit of the US economy together with the worsening of its net foreign asset position

— could make it desirable for a country to manipulate its nominal exchange rate value

to improve its net foreign asset position. Cavallo and Tille (2006) show for the US that

capital gains due to the depreciation of the dollar during the period 2002 to 2004 were

1See e.g. Lane and Milesi-Ferretti (2003, 2006b) as well as Tille (2005) for more details on theevolution of international financial linkages.

3

able to offset about half of the US current account deficit. Reciprocally, Tille (2003)

showed that the strengthening of the dollar during 1999 to 2001 accounted for 30% of

the decline in the net international investment position.2 Thus, besides increasing the

portfolio return on foreign asset holdings, a depreciation of the domestic currency results

in a wealth transfer to the domestic economy.

However, valuation effects may also be due to other price changes, e.g. changes in

asset prices or the value of FDI. Furthermore, besides the impact on the value of assets

and liabilities, an exchange rate change induced by monetary policy will also alter the

domestic currency returns on foreign assets.3 Yet, the latter may as well be affected by

variations in the underlying returns. The contribution of this paper is to account for the

variety of implications due to increased financial integration by allowing for all three

possible international linkages — trade in bonds and equities across countries as well as

FDI — jointly. As shown by Lane and Milesi-Ferretti (2005a), this extension is also of

empirical relevance, as the relative importance of both FDI and portfolio equity in the

foreign asset and liability positions has increased during the past 20 years.

Given the examples above and the diversified structure of the foreign portfolio hold-

ings across countries, it will be analyzed under which conditions it might be desirable

for a country to manipulate the nominal exchange rate to improve its welfare. How

important is the composition of the foreign portfolio position for the results? Is there a

role for monetary policy to govern the nominal exchange rate behavior? What are the

spillover effects of such a policy for other countries and what could be the consequences

for overall macroeconomic stability if one country makes use of the valuation effect to

increase its net foreign asset position?

In this paper we address these questions by means of a two-country DSGE model

with price-rigidities and capital accumulation, where we incorporate a diversified foreign

asset portfolio of countries. More precisely, the financial market structure allows for trade2Corresponding results are also shown in Abora (2004) and in Lane and Milesi-Ferretti (2005b).3For an empirical investigation on return differentials see Lane and Milesi-Ferretti (2005b).

4

in bonds and in portfolio equities across countries as well as for foreign direct investment

(FDI). Although there are a number of authors which have looked at valuation effects in

these models (see for instance Ghironi, Lee and Rebucci (2005), Tille (2005) and Cavallo

and Tille (2006)), to our knowledge none of these approaches has yet incorporated all

three types of international financial linkages jointly (in particular not FDI). It will be

shown that especially the latter proves to be important for our results.4

In the model derived, the world is assumed to consist of two equal-sized countries,

each inhabited by a continuum of representative agents as well as of a continuum of

monopolistic firms, each producing a differentiated good with the two available factors

labor and capital. Agents can trade two internationally traded riskless bonds as well as

home and foreign equities (i.e. shares of home and foreign firms). Besides, agents can ac-

cumulate capital abroad via foreign direct investment. The latter two assumptions allow

for wealth and income effects in addition to the pure valuation effect in response to an

exchange rate change. It will be shown that under certain circumstances (i.e. producer-

currency pricing), these effects can be more important than the pure redistributional

effect caused by the change in the exchange rate. Even though the model is log-linearized

around a symmetric steady state where each country’s net foreign asset position is zero,

gross international investment positions that differ from zero are allowed. In the follow-

ing, the effects of a permanent expansionary monetary policy shock in the home country

are simulated and analyzed, where we consider different international investment sce-

narios for two alternative price-setting assumptions, producer-currency pricing (PCP)

and local-currency pricing (LCP). The main results are the following:

As long as the redistributional effect of an exchange rate change dominates, a de-

preciation of the home currency raises the net foreign asset position (and thus welfare)

of a country which is indebted in its own currency and holds foreign assets denoted in4Notice that there are two factors of production in our model and we abstract from sticky-wages

in the current setting. Hence, as demand goes up and firms cannot adjust prices, profits decline. As aresult, trade in equities does not have the same risk-sharing properties as in Tille (2005), where labor isthe only input and he considers wage-rigidities in addition to price rigidities. Yet, we intend to includethese features in a later version.

5

the foreign currency. As an exchange rate change represents a zero-sum situation, the

foreign country, on the other hand, is always worse off compared to a situation with no

foreign portfolio position.

With foreign bond holdings, this effect is the dominant effect, independent of the

price-setting behavior of firms, which can either be PCP or LCP.5 Besides the exchange

rate change, the value of foreign equities is also affected by asset price changes which

will vary with expected profits. In our simulations, in addition to the exchange-rate

effect relative foreign equity prices rise, which increases the redistribution of wealth

from foreign to home households in response to a monetary expansion.6

Yet, this does not hold with respect to foreign direct investment. Even though in

the setting with FDI only, the exchange-rate effect is still at work, a different channel

of redistribution emerges, as returns on FDI vary with variations in aggregate demand

for foreign products. Hence, with complete PCP, a high exposure to FDI induces an

effect in the opposite direction. Due to the expenditure-switching effect, induced by

the depreciation, demand for home products rise. As firms are not free to adjust prices

immediately, but instead are bound to satisfy higher demand, they will have to pay

higher prices for their inputs, capital and labor. If the capital stock, which is used for

the production of home goods, is owned in part by foreign households, the latter will

equally participate from the boom in demand. Depending on the relative size of foreign

bond exposure and the variability of returns on FDI, this effect might even more than

compensate the exchange-rate effect. In this case, the foreign country might benefit from

a depreciation of the home currency.

However, this is not true for complete LCP. As in this case import prices (and thus

relative prices) are no longer affected by a depreciation of the exchange rate, demand

increases for both home and foreign goods proportionately. As a result, the risk-sharing

property of FDI is less important in such a situation.

5Besides the redistribution of wealth, the depreciation also raises returns of home households ontheir bonds denominated in the foreign currency, increasing current income.

6The short-run income effect works again in the same direction as dividends on home equities falldue to a decline in home firms’ profits, reducing foreign households real income.

6

Hence, in this paper we show that the wealth- and welfare-enhancing effects of a

depreciation of the home currency face a counterbalance when FDI is incorporated in

this type of model. With FDI, foreign households can participate in the boom in demand

for home goods induced by a monetary expansion, and the risk of demand shocks is

shared between home and foreign agents. Thus, in such a situation a depreciation of the

home currency is no longer necessarily welfare-improving for the home country.

The structure of the paper is as follows. In the next section, the model is derived

and the structure of international financial integration is described in detail. Section

3 presents the results. For illustrational purposes, the impulse response functions for

the relevant home and foreign variables in response to a single permanent 1% increase

in home money supply are presented and discussed for a number of settings where we

investigate different international investment positions in the steady state as well as

alternative price-setting strategies. Section 4 then concludes.

2 The Model

In the following, a two-country dynamic general equilibrium model with nominal price

rigidities in the tradition of the New Open Economy Macroeconomics is derived. The

world is assumed to consist of two countries, home and foreign, each inhabited by a

continuum of agents normalized to 1. Agents consume consumption goods, supply la-

bor and accumulate capital which they rent out to firms. A continuum of individual

monopolistic firms resides in the home and the foreign country, which are respectively

indexed by zh ∈ [0, 1] and zf ∈ [0, 1]. Each firm produces a single differentiated good,

whereas labor and capital in each country are assumed to be homogenous and can be

substituted across firms within one country without any cost. To distinguish foreign

from home agents, the foreign variables will be identified with an asterisk.

7

2.1 Individual preferences and prices

Preferences of the representative Home agent i are given by the following utility function

U = Et

∞Xs=t

βs−t"C1−σs

1− σ+

χ

1−µMs

Ps

¶1−+ η ln (1− Ls)

#(1)

The intertemporal elasticity of substitution between consumption today and tomorrow

is given by 1σ. The parameter η can be seen as a shift parameter in the marginal utility of

leisure. The shift parameter in money demand is reflected by χ and the interest elasticity

of money demand is given by β . Real balances are equal to MP. The home consumer price

index at time t is derived as

Pt =

·λ¡P ht

¢1−µ+ (1− λ)

³P ft

´1−µ¸ 11−µ

, (2)

where µ reflects the parameter of the elasticity of substitution between home and foreign

goods and λ denotes the degree of home bias in consumption. The price indices for the

composite goods are defined as

P ht =

1Z0

¡pht¡zh¢¢1−θ

dzh

1

1−θ

(3)

P ft , the home price index for imported goods from the foreign country, is correspondingly

defined as a weighted average of the home currency price of each foreign good variety

zf . The consumption index of the home country can be written as follows:

Ct =

µλ1µ¡Cht

¢µ−1µ + (1− λ)

1µ

³Cft

´µ−1µ

¶ µµ−1

, (4)

with

Cht =

1Z0

cht¡zh¢ θ−1

θ dzh

θ

θ−1

, Cft =

1Z0

cft¡zf¢ θ−1

θ dzf

θ

θ−1

. (5)

8

The elasticity of substitution between any two heterogeneous goods is reflected by θ > 1.

The conditional commodity demand functions in the home and foreign country are

derived by minimizing the expenditure for the composite goods z and are given by

cht¡zh¢= λ

Ãpht¡zh¢

P ht

!−θ µP ht

Pt

¶−µCt, (6)

cft¡zf¢= (1− λ)

Ãpft¡zf¢

P ft

!−θÃP ft

Pt

!−µCt. (7)

Similar results hold for the foreign economy.

2.2 Asset Allocation

The main contribution of this paper is that we allow for three different types of inter-

national financial integration jointly. First, agents can internationally trade two riskless

bonds, one denominated in the home and the other in the foreign currency. Second,

they might purchase shares of both home and foreign firms. Finally, agents can also

accumulate capital in the respective foreign country which is then used in the foreign

production process by foreign firms. In the following, the three asset types — in addition

to domestic money — are described in more detail

2.2.1 International Bonds

First, agents can trade two risk-free bonds Bht and B

ft , where the former is denominated

in the home and the latter in the foreign currency. The bonds yield the nominal riskless

interest rate it and i∗t between period t − 1 and t, respectively, and are assumed to be

perfect substitutes. Risk free bonds are in zero net supply, hence:

Bht = −Bh∗

t (8)

and

Bft = −Bf∗

t . (9)

9

2.2.2 Foreign Direct Investment

Besides bonds, agents can also undergo foreign direct investment Ft (F∗t ) to accumulate

capital in the respective foreign country which is then used in the foreign production

process by foreign firms. Capital is assumed to depreciate at a constant rate δ and is

subject to adjustment costs. The importance of capital adjustment costs is determined by

φ and φ∗, where the latter parameter accounts for the possibility that capital adjustment

costs might be more important for foreign direct investment, as the administrative and

other obstacles related to foreign direct investment might be higher.

The law of motion for the domestically and foreign owned capital stock available for

production in the home country are

Kht+1 = (1− δ)Kh

t + Vt − φ

2

©Kh

t+1 −Kht

ª2Kh

t

, (10)

Kft+1 = (1− δ)Kf

t + F ∗t −φ∗

2

nKf

t+1 −Kft

o2Kf

t

, (11)

where Vt denotes investment of home agents in their home capital stock and F ∗t denotes

foreign direct investment in the home capital stock of foreign agents. For investment in

the foreign capital stock, the law of motion takes the following form

Kh∗t+1 = (1− δ)Kh∗

t + Ft − φ∗

2

©Kh∗

t+1 −Kh∗t

ª2Kh∗

t

, (12)

Kf∗t+1 = (1− δ)Kf∗

t + V ∗t −φ

2

nKf∗

t+1 −Kf∗t

o2Kf∗

t

. (13)

where Ft denotes foreign direct investment of home agents and V ∗t denotes investment of

foreign agents in their own country’s capital stock. Absolute adjustment costs are higher,

the higher the absolute change of the capital stock, Kht

¡Kh∗

t

¢and Kf

t

³Kf∗

t

´, and the

smaller the initial capital stocks. Capital is assumed to be homogenous but is immobile

between countries. As a result, for the production process of firms, the ownership of

the capital stock is irrelevant, and capital can be substituted across firms within one

10

country without cost.

Each period, domestic and foreign agents rent their existing capital stock in the

home (foreign) country to home (foreign) firms and receive the nominal interest rate

PtrKt (StP ∗t r

k∗t ) per unit. Hence, the nominal return on domestically owned capital in

the foreign country amounts to StP ∗t rk∗t Kh∗

t

³PtrktSt

Kft

´.

2.2.3 Foreign Equity

Finally, each domestic (foreign) household can also purchase equities in form of claims

on weighted aggregate profits of home and foreign firms Πt (Π∗t ), reflected by Q

Ht

¡QH∗t

¢and QF

t

¡QF∗t

¢, respectively.7 As equities represent shares of home and foreign firms, the

overall supply of home and foreign equities is fixed and given by

Q̄F = QF∗ +QF (14)

and

Q̄H = QH∗ +QH (15)

The price for one unit of home equity is qt (³qtSt

´), the respective price for a unit of foreign

equity is Stq∗t (q∗t ), both adjusted by the nominal exchange rate St when the purchase

occurs abroad. Whenever home (foreign) households like to adjust their position in

equities they need to account for equity adjustment costs, ϕ2

(QHt+1−QH

t )2

QHt

and ϕ2

(QFt+1−QF

t )2

QHt

(ϕ2

(QH∗t+1−QH∗

t )2

QH∗t

and ϕ2

(QF∗t+1−QF∗

t )2

QH∗t

) which are payable to the respective government of

the country where the equity is issued. Distinct from capital adjustment costs, equity

adjustment costs are redistributed to home (foreign) agents as a lump-sum transfer.

7We assume that the firms’ profits are proportionally redistributed as dividends to the firms’ share-holders.

11

2.3 Budget Constraint

Taking the diversified portfolio structure into account, the home agent’s budget con-

straint at time t then becomes:

PtCt + PtVt + StP∗t Ft +Mt + Stq

∗t

¡QF

t+1 −QFt

¢µ1 +

ϕ

2

QFt+1 −QF

t

QFt

¶(16)

+qt¡QH

t+1 −QHt

¢µ1 +

ϕ

2

QHt+1 −QH

t

QHt

¶+Bh

t+1 + StBft+1

= WtLt +Mt−1 + PtrktK

ht + StP

∗t r

k∗t Kh∗

t +

·St

Π∗tQ̄F

QFt +

Πt

Q̄HQHt

¸+(1 + it)B

ht + St (1 + i∗t )B

ft + Ptτ t

Thus, each period, the household allocates resources between consumption PtCt, nom-

inal balances, Mt, home and foreign bonds Bht+1 + StB

ft+1, home and foreign equities,

qt¡QHt+1 −QH

t

¢ ³1 + ϕ

2

QHt+1−QH

t

QHt

´and Stq

∗t

¡QF

t+1 −QFt

¢ ³1 + ϕ

2

QFt+1−QF

t

QFt

´, and domestic

as well as foreign direct investment, PtVt and StP∗t Ft. The resources of the household

consist of redistributed profits on home and foreign firm shares, Πt

Q̄HQHt and St

Π∗tQ̄F Q

Ft ,

nominal wage income WtLt, the return on investment in the domestic and foreign capi-

tal stock, PtrktK

ht and StP

∗t r

k∗t Kh∗

t , the returns on bonds, (1 + it)Bht and St (1 + i∗t )B

ft ,

a lump-sum transfer by the government, Ptτ t, and the cash holdings Mt−1 from the

previous period.

The maximization of the objective function (1) subject to the budget constraint (16)

leads to the following first order conditions:

C−σt = βEt

C−σt+1(1 + it+1)Pt

Pt+1| {z }≡(1+rt+1)

(17)

Mt

Pt=

µχC−σt Et

µ(1 + it+1)

it+1

¶¶1

(18)

Wt

Pt=

η

C−σt (1− Lt)(19)

12

The first optimality condition (17) is the Euler equation which determines the optimal

intertemporal consumption path. The higher the expected home real interest rate rt+1,

the higher the opportunity cost for consumption today, and the more the household will

be inclined to postpone consumption to the next period. Money demand is shown in

equation (18). The demand for real money balances is increasing in real consumption ex-

penditures and declines with an increase in the nominal interest rate as the opportunity

cost of holding the non-interest bearing asset rises. The third optimality condition (19)

determines the optimal labor supply, which is increasing in the real wage and decreasing

in consumption. Hence, households supply labour to the point where the marginal disu-

tility of labour equals its marginal benefit. The optimal portfolio choice between home

and foreign bonds implies that

(1 + it+1)Et

·C−σt+1

Pt+1

¸=¡1 + i∗t+1

¢Et

·C−σt+1

Pt+1

µSt+1St

¶¸. (20)

Equation (20) reflects the optimal choice between home and foreign bonds, which for

the assumption of certainty equivalence employed below results in the uncovered interest

rate parity, (1 + i∗t )Et(St+1)

St= (1 + it).

The optimal portfolio choices with respect to equities and capital are determined by

taking adjustment costs and the law of motion for the capital stock (10) and (12) into

account and result in the following optimality conditions for the investment in home

and foreign equities

C−σt

Ptqt

·1 + ϕ

QHt+1 −QH

t

QHt

¸= βEt

"C−σt+1

Pt+1

Ãqt+1

Ã1 +

ϕ

2

¡QH

t+2

¢2 − ¡QHt+1

¢2¡QHt+1

¢2!+

Πt+1

Q̄H

!#(21)

C−σt

PtStq

∗t

·1 + ϕ

QFt+1 −QF

t

QFt

¸= βEt

"C−σt+1

Pt+1St+1

Ãq∗t+1

Ã1 +

ϕ

2

¡QF

t+2

¢2 − ¡QFt+1

¢2¡QFt+1

¢2!+

Π∗t+1Q̄F

!#(22)

13

and for home and foreign direct investment

µ1 + φ

Kh∗t+1 −Kh∗

t

Kh∗t

¶C−σt

P ∗t StPt

= βEt

"P ∗t+1St+1Pt+1

Ã1 + rK∗t+1 − δ +

φ

2

¡Kh∗

t+2

¢2 − ¡Kh∗t+1

¢2¡Kh∗

t+1

¢2!C−σt+1

#(23)µ

1 + φKh

t+1 −Kht

Kht

¶C−σt = βEt

"Ã1 + rKt+1 − δ +

φ

2

¡Kh

t+2

¢2 − ¡Kht+1

¢2¡Kh

t+1

¢2!C−σt+1

#(24)

Equation (21) reflects the domestic household’s optimal equity investment decision. The

cost due to forgone consumption in order to increase today’s equity holding by one unit

(plus the marginal equity adjustment costs) has to equal the marginal income derived

from the equity holdings, which consists of the increase in the equities itself, the expected

dividend payments, Et

³Πt+1Q̄H

´, possible price changes qt+1 plus the expected decrease in

equity adjustment costs. A similar relationship holds for the purchase in foreign equities,

with an explicit role for the nominal exchange rate St.

The household’s optimal capital investment decisions are determined by equations

(24) and (23). Similarly, for the household to be indifferent between additional invest-

ment in the home (foreign) capital stock and more consumption, the cost borne in terms

of forgone utility of consumption in order to increase today’s home (foreign) capital stock

by one unit has to be equal to the marginal to the marginal utility derived from the

home (foreign) investment.

The optimization of the foreign country is similar to the home country and results

in the corresponding optimality conditions.

2.4 Demand

For simplicity, we assume that investment of home (foreign) agents in the capital stock of

the home economy, Vt (F ∗t ), features the same composition as the consumption basket of

home agents. The corresponding is true for capital investment of foreign (home) agents

in the foreign country, V ∗t (Ft). Thus, together with the consumption demand derived

in equations (6) and (7) the overall demand for the representative home good by firm h

14

equates to

yht (h) = λ

µpht (h)

P ht

¶−θ µP ht

Pt

¶−µ[Ct + Vt + F ∗t ]

+ (1− λ)

µph∗t (h)P h∗t

¶−θ µP h∗t

P ∗t

¶−µ[C∗t + V ∗t + Ft] . (25)

A similar condition holds for the foreign representative firm. Since all firms produce

a differentiated good, each firm faces an individual demand schedule which it takes as

given when choosing its price to maximize profits. The profit maximization then depends

on the form of price rigidities.

2.5 Firms

In an environment of monopolistic competition, each firm will set its price so as to

maximize expected profits, taking its individual demand schedule, equation (25), into

account. Price rigidities à la Calvo (1983) are included.8 In order to analyze whether

the resulting effects in response to a monetary shock for different international invest-

ment positions in the steady state are sensitive to different price-setting strategies, two

alternative price-setting regimes are considered: producer-currency-pricing (PCP) and

local-currency-pricing (LCP).9 Whereas a PCP firm sets the price for its good in the

domestic currency of the producer, independent of the market where the good is sold,

the LCP firm is assumed to set two different prices, one for the home market and one

for the foreign market, each in the local currency of the market. In the presence of

short-run price rigidities, import prices of PCP goods exhibit a complete exchange-rate

pass-through while import prices of LCP goods are not affected by a change in the

exchange rate.

8Each firm faces the same constant probability (1− γ) every period to change its price next period.9Betts and Devereux (2001, 2000, 1996), Engel (2000) and Schmidt (2006) have shown that the

international transmission effects of monetary policy shocks are crucially affected by the way firms settheir prices.

15

2.5.1 Profit maximization

Profit maximization of the representative PCP firm In the presence of price

rigidities à la Calvo, firms set prices so as to maximize their expected discounted future

profits, which are given by: 10

Et

" ∞Xi=0

(γβ)iΛt,t+i

Ã eP h,PCPt (h)

Pt+i− MCt+i

Pt+i

!yh,PCPt,t+i (h)

#

with Λt,t+i =³Ct+iCt

´−σ. yh,PCPt,t+i (h) denotes the expected total demand of the rep-

resentative home PCP firm at time t + i provided that the price set at time t is still

effective. The optimal price of the representative home PCP firm at time t, eP h,PCPt (h), is

then derived as a markup over a weighted average of expected future nominal marginal

costs:

eP h,PCPt (h) =

θ

θ − 1Et

hP∞i=0 (γβ)

i Λt,t+iDh,PCPt,t+i MCt+i

iEt

hP∞i=0 (γβ)

i Λt,t+iDh,PCPt,t+i

i (26)

Dh,PCPt,t+i denotes total expected future real sales revenues of the PCP firm, given that

the optimal price chosen at time t is still effective. Since all PCP firms in the home

country face the same constraints, each firm that can adjust its price in period t will

choose the same price eP h,PCPt (h). The home country price index for home PCP goods

P h,PCP is then a weighted average of last period’s price index and the optimal price at

time t:

P h,PCPt =

·γ³P h,PCPt−1

´1−θ+ (1− γ)

³ eP h,PCPt (h)

´1−θ¸ 11−θ

(27)

Profit maximization of the representative LCP firm The representative LCP

firm faces essentially the same optimization problem as the PCP firm, but maximizes

10A notational remark: The superscript PCP identifies goods produced and prices charged by PCPfirms, the superscript LCP marks the respective variables for LCP firms.

16

profits arising from the home and the foreign market, choosing two different prices:

Et

" ∞Xi=0

(γβ)i Λt,t+i

Ã eP h,LCPt (h)

Pt+i− MCt+i

Pt+i

!yh,LCPt,t+i (h)

+ (γβ)i Λt,t+i

ÃSt+i eP h,LCP,∗

t (h)

Pt+i− MCt+i

Pt+i

!yh,LCP,∗t,t+i (h)

#

eP h,LCP,∗t (h) denotes the optimal export price of the representative home LCP firm set

in the foreign currency, which is converted to the home currency via the exchange rate

St+i. The quantities yh,LCPt,t+i and yh,LCP,∗t,t+i denote home and foreign agents’ demand for

the representative home LCP good at t+ i given the prices eP h,LCPt (h) and eP h,LCP,∗

t (h)

set at time t.

In the log-linearized version of the model, the optimal price in the domestic market

of the LCP firm is identical to the PCP firm’s price. This implies that the home price

index for domestically produced goods, defined in equation (3) above, is simply written

as:

P ht = P h,PCP

t (28)

The optimal export price eP h,LCP,∗t (h) of the representative home LCP firm is derived

as:

eP h,LCP,∗t (h) =

θ

θ − 1Et

hP∞i=0 (γβ)

i Λt,t+iDh∗,LCPt,t+i

MCt+iSt+i

iEt

hP∞i=0 (γβ)

iΛt,t+iDh∗,LCPt,t+i

i (29)

As the LCP price for the foreign market is set in the foreign currency, the optimal

newly set price also depends on the expected future path of the nominal exchange rate,

as the LCP firm takes into account the increase in markup resulting from a devaluation

of the home currency. As export prices of PCP and LCP firms differ, the price index

of imported goods in the home economy is a weighted average of the average prices of

foreign LCP and PCP goods P f,LCPt and P f,PCP,∗

t targeted at the home market. The

respective weights are determined by the share of LCP firms, s. Therefore, the home

17

price index of imported foreign goods simplifies to:

P ft =

·s³P f,LCPt

´1−θ+ (1− s)

³StP

f,PCP,∗t

´1−θ¸ 11−θ

(30)

2.5.2 Production

The paper aims at exploring the consequences of international capital and financial

integration. Therefore, we introduced foreign direct investment, i.e. home agents can

also accumulate capital in the foreign country and vice versa. As a result, the overall

capital stock available for production in the home country consists of capital owned by

domestic, Kht , and foreign residents, K

ft , and can be specified by

Kt = Kht +Kf

t . (31)

Production in each country then takes place out of accumulated domestic and foreign

direct investment. In the foreign economy, the capital stock available for foreign firms

correspondingly consists of capital owned by foreign as well as by home agents. Thus, a

similar condition,

K∗t = Kf∗

t +Kh∗t , (32)

is valid. Firms at home and abroad produce under constant-returns-to-scale, employing

the following Cobb-Douglas production function yt (h) = AtKt (h)α Lt (h)

1−α, displayed

for the example of the representative home firm h. At represents the common level of

technology in the home country, while Kt (h) and Lt (h) denote the individual capital

and labor inputs of the representative home firm h. Cost minimization implies that firms

will demand factor inputs to satisfy the wage rate,

Wt =MCt (1− α)yht (h)

Lt (h)=MCt (1− α)

yhtLt, (33)

18

and the nominal interest rate

PtrKt =MCtα

yht (h)

Kt (h)=MCtα

yhtKt

. (34)

MCt denotes the nominal marginal costs of production. Since all firms in one country

have to pay the same wage and face the same rental rate for capital, marginal costs

are the same across all firms residing in one country. A similar condition is true for the

foreign country.

2.6 The Consolidated Budget Constraint

For simplicity, it is assumed that all seignorage revenue accruing to the central bank

as well as the equity adjustment costs received by the government are redistributed to

the households in form of a lump-sum transfer. Hence, the home country’s governments

budget constraint equates to

Ptτ t =Mt −Mt−1 +ϕ

2

Stq∗t

¡QFt+1 −QF

t

¢2QF

t

+ϕ

2

qt¡QH

t+1 −QHt

¢2QH

t

(35)

Taking the lump-sum redistribution of seignorage and equities adjustment costs into

account, the consolidated budget constraint of the home economy (16) reduces to

PtCt + PtVt + StP∗t Ft + Stq

∗t

¡QFt+1 −QF

t

¢+ qt

¡QH

t+1 −QHt

¢+Bh

t+1 + StBft+1 (36)

= WtLt + PtrktK

ht + StP

∗t r

k∗t Kh∗

t +

·St

Π∗tQ̄F

QFt +

Πt

Q̄HQHt

¸+ (1 + it)B

ht + St (1 + i∗t )B

ft

2.7 Current Account and Net Foreign Assets

The current account can be written in terms of international financial flows as

CAt = Stq∗t

¡QF

t+1 −QFt

¢+ qt

£QH

t+1 −QHt

¤(37)

+¡Bht+1 −Bh

t

¢+ St

³Bft+1 −Bf

t

´+ StP

∗t Ft − PtF

∗t ,

19

Employing the consolidated budget constraint derived in equation (36), the current

account can then also be expressed as

CAt =WtLt+PtrktK

ht +StP

∗t r

k∗t Kh∗

t +

·St

Π∗tQ̄F

QFt +

Πt

Q̄HQH

t

¸+itB

ht +Sti

∗tB

ft −PtCt−PtVt−PtF

∗t

By definition, the current account measures financial flows which affect the net for-

eign asset position of countries. Yet, the latter is also affected capital gains and losses

due to exchange rate and price changes. Taking these valuation effects into account, the

change of the net foreign asset position can be expressed as

NFAt+1 −NFAt = CAt − StP∗t

"δKh∗

t +φ

2

©Kh∗

t+1 −Kh∗t

ª2Kh∗

t

#+ Pt

δKft +

φ

2

nKf

t+1 −Kft

o2Kf

t

(38)+Bf

t (St − St−1) +¡Stq

∗t − St−1q∗t−1

¢QF

t + (qt − qt−1)QHt

+Kh∗t

¡StP

∗t − St−1P ∗t−1

¢−Kft (Pt − Pt−1) .

The valuation effects - measured in the domestic currency - consist of revaluing

foreign bonds, home and foreign equities as well as home and foreign capital because of

price and exchange rate changes. Note that we also subtract capital depreciation and

adjustment costs from the change in net foreign assets, as capital adjustment costs due

to FDI do not raise the foreign asset position (although they are included in the current

account measure) while capital depreciation reduces it. Hence, the changes in the net

foreign asset position are driven by the current account and valuation changes, which

originate from changes in the asset prices in conjunction with the exchange rate.

2.8 Market Clearing Conditions

In equilibrium, all goods, factor and asset markets need to clear in the home and the

foreign economy. In the home goods market, aggregated demand consists of demand for

LCP and PCP goods:

Y ht = sY h,LCP

t + (1− s)Y h,PCPt (39)

20

Since all home firms produce with the same capital-labor ratio, total supply in the

home country can be written as:

Y ht =

Z 1

0

AtKαt

¡zh¢H1−α

t

¡zh¢dzh = AtK

αt H

1−αt (40)

The foreign goods market clears analogously. The home (foreign) money market

is in equilibrium if national money demand corresponds to the exogenous supply of

home (foreign) currency provided by the national central bank. Bond markets clear in

equilibrium if home and foreign bonds are in zero net supply worldwide as described in

equations (8) and (9). By the same token, equity markets clear if home and foreign equity

are in zero net supply, i.e. equations (14) and (15) hold. For factor markets to clear,

total demand for capital and labor of home (foreign) firms resulting from production

decisions derived in equations (33) and (34) have to equal capital and labor supplied in

the home (foreign) country, Kt and Lt (K∗t and L∗t ).

2.9 Equilibrium

Equilibrium is characterized by equations (2), (10), (12), (17), (18), (19), (21), (22), (24),

(23), (28), (26), (29), (30), (33), (34), (36), (39), (40), and their foreign counterparts,

demand equation (25) and average price equation (27) for both LCP and PCP goods in

the home and the foreign economy, as well as equations (20) and the bonds and equities

market equilibria (8), (9), (15) and (14) which gives 51 equations. This is a dynamic

system in the following thirty-nine variables, given by:

Xt = {Ct, C∗t , Lt, L

∗t , Vt, V

∗t , Ft, F

∗t , K

ht ,K

h∗t ,Kf

t ,Kf∗t , QH

t , QH∗t , QF

t , QF∗t ,

Wt,W∗t , r

kt , r

k∗t , it, i

∗t , qt, q

∗t ,MCt,MC∗t , St, B

ht , B

h∗t , Bf

t , Bf∗t,

Pt, P∗t , P

ht , P

ft , P

h∗t , P f∗

t , eP h,PCPt , eP h,LCP,∗

t , eP f,PCPt , eP f,LCP

t , P h,PCPt ,

P h,LCPt , P f,PCP

t , P f,LCPt , Y h

t , Yft , Y

h,PCPt , Y h,LCP

t , Y f,PCPt , Y f,LCP

t }

21

The model is solved by linearizing around a symmetric steady state, where the net

foreign asset position of both countries is zero.11 However, we allow for different degrees

of international financial integration in the steady state, i.e. positive gross asset and

liability holdings.

2.10 Calibration

The calibrated parameters are presented in Table 1. The quarterly real interest rate is set

to 1% in the steady state. The consumption elasticity of money demand (σ in the model)

is commonly estimated to be about unity, see, e.g., Mankiw and Summer (1986), which

is the value we adopt. For the interest elasticity of money demand (−β in the model),

the estimates vary from −0.39 in Chari et al. (2002) to −0.051 in Mankiw and Summers(1986).12 For the benchmark calibration, we choose −0.39. The benchmark values formoney demand elasticities imply that σ is about 2.5. The parameter θ determines the

markup of prices over marginal costs. Consistent with the findings of Basu and Kimball

(1997), which suggest a markup of about 10% in the U.S., we assume θ = 10. The

capital share α is set to 13. This value is in line with empirical evidence on the labor

share provided by Bentolila and Saint-Paul (2003), which is found to range from 62%

to 68% for the G-7 countries in the 1990s. The rate of depreciation δ is set to 0.021,

which implies an annual depreciation rate of about 10%, corresponding to the typical

estimates for U.S. data. The steady state share of labour,H0, is set to 0.3. For simplicity,

the relative preference parameter for real balances, χ, is assumed to be 1. The last two

assumptions further determine η, the preference parameter for leisure, to be 2.8. The

price adjustment parameter is set such that the average time between price adjustment

for a firm is one year. This implies γ = 0.75. The import share in the steady state is

assumed to be 15% for both countries. While the U.S. average import share in the post

11For the solution of the model, the MATLAB code provided by Schmitt-Grohé and Uribe (2004) isemployed.

12Both Chari et al. and Mankiw and Summers use consumption as the relevant quantity variable forthe estimation of money demand elasticities, which corresponds to the setup in the model. Chari et al.(2002) also implicitly assume a unity consumption elasticity of money demand in their regression.

22

Bretton Woods era amounts to about 11%, import shares in the remaining G-7 countries

during this time period range from 10% in Japan to almost 30% in Canada. The value

for capital adjustment costs φ is set to 8, which induces an investment response to

an unanticipated increase in home money supply for the baseline calibration of about

3 times the size of the corresponding output response in the home country, and thus

corresponds to the findings of the VAR analysis. Equity adjustment costs are needed

in order for equity demand to be determined. Yet, to keep the distortion small, the

adjustment cost parameter ϕ is set to 0.1. Finally, the elasticity of substitution between

home and foreign goods µ is set equal to 1.5 as found by Hooper and Marquez (1995,

Table 4.1) for the U.S. The degree of pricing to market s is either set to 0 or 1.

Table 1: Calibrated parametersσ 2.5 χ 1 θ 10

2.5 δ 0.021 µ 1.5φ 8 β 1

1.01ϕ 0.1

η 2.8 α 13

γ 0.75

3 Results

In the following, the effects of a 1% permanent increase in home money supply are

simulated and analyzed for eight different alternative scenarios, where we consider four

different international investment scenarios for two alternative price-setting assump-

tions. For each of the two pricing assumptions of firms, local-currency pricing (LCP)

and producer-currency pricing (PCP), we consider a benchmark scenario with no posi-

tive international investment position in the steady state.13 Second, we investigate the

case where in the steady state, only international bond holdings occur. In the third

scenario, we look at the effects of monetary policy shocks for the existence of positive

investment position in the steady state of FDI only. In the last scenario, we consider

positive international investment positions in bonds, equities and FDI jointly.

13Notice, however, that households are allowed to trade bonds in response to shocks.

23

The plotted impulse responses (IR) are percentage deviations from respective steady-

state values, except for the interest rates, the current account and net foreign assets. For

the interest rates, the deviations depicted are in percentage-points, while the current

account and the net foreign asset position is defined in percent of steady-state home

nominal income. Solid (dashed) lines show the responses of the first (second) variable.

The horizontal axes depict the number of quarters.

3.1 Producer Currency Pricing

3.1.1 Benchmark PCP

Figure (1) displays the IR for the benchmark scenario with complete PCP obtained for

a 1% permanent increase in home money supply. As can be seen, a monetary policy

shock in the home country raises home and foreign consumption and investment. Yet,

due to the expenditure-switching effect, only home production increases whereas foreign

production remains almost unchanged. Yet, due to the deterioration of the terms of

trade, foreign real income increases. At the same time, the home economy runs a current

account surplus. In terms of welfare, the foreign country benefits from the increase in

consumption, whereas home agents also have to supply more labor, resulting only in

a small increase in utility.14 With no positive international investment position in the

steady state, no valuation effect emerges and the net foreign asset position is solely

driven by capital flows, i.e. cumulated current account surpluses.

3.1.2 Bonds only

In the bonds-only scenario, the home country owns foreign currency denominated bonds

amounting to 100% of home nominal GDP in the steady state. At the same time, it has

liabilities of the same order in the home currency bond. Hence, the net foreign asset

position is again zero, but the international investment position is positive in the steady

state, and a valuation effect in response to exchange rate changes will occur. Figure (2)

14See Schmidt (2006) for this result.

24

Figure 1: Impulse Responses for the Benchmark PCP scenario without any positiveinternational investment position in the steady state

0 10 20−0.5

0

0.5

1output: home, foreign

0 10 200

0.2

0.4consumption: home, foreign

0 10 20−2

0

2

4dom. investment: home, foreign

0 10 20−1

−0.5

0terms of trade

0 10 20−0.01

−0.005

0ib, ib*

0 10 200

0.5

1

1.5nom. and real exch. rate

0 10 20−20

−10

0

10profits h and f

0 10 200

0.2

0.4current account, NFA

0 10 20−0.5

0

0.5

1real income h and f

time

0 10 20−1

0

1valeff

time

displays the corresponding results in response to a 1% increase in home money supply.

For the bonds-only scenario, a depreciation of the home currency raises the net

foreign asset position of the home country as the home currency value of foreign currency

denominated assets rises. Hence, in this case the exchange rate change redistributes

wealth from the foreign to the home country. At the same time, the interest payments

on foreign assets converted to home currency increase due to the depreciation. As a

result, foreign consumption is lower compared with the benchmark scenario and the

foreign country is worse off while home country’s situation improves compared to a

situation with no international investment position.

25

Figure 2: Impulse responses for B=100%, PCP

0 10 200

0.5


0 10 200

0.2


0 10 20−2

0

2


0 10 20−1

−0.5

0

0.5terms of trade

0 10 20−0.01

−0.005

0ib, ib*

0 10 20−0.5

0

0.5

1nom. and real exch. rate

0 10 20−20

−10

0

10profits h and f

0 10 200

0.5

1


0 10 20−0.5

0

0.5


time

0 10 20−0.2

0

0.2valeff

time

3.1.3 FDI only

In the third scenario, we investigate a steady state where both home and foreign house-

holds each own half of the capital stock in the home and the foreign country. The

corresponding impulse responses are depicted in Figure (3).

If FDI is the only international investment position in the steady state, a different

channel of redistribution emerges, as returns on FDI vary with variations in aggregate

demand for foreign products. Although the value of the capital stock in the foreign

country owned by home agents increases in terms of home currency as before, after a

couple of periods this effect is more than offset by the increase in returns which foreign

26

Figure 3: Impulse Responses for Foreign Direct Investment, PCP

0 10 20−0.5

0

0.5


0 10 200

0.2


0 10 20−2

0

2


0 10 20−1

−0.5

0terms of trade

0 10 20−0.01

−0.005

0ib, ib*

0 10 200

0.5

1


0 10 20−0.1

0

0.1profits h and f firms

0 10 20−2

0

2

4current account, NFA

0 10 20−0.5

0

0.5


0 10 20−2

0

2

4FDI home & foreign

time0 10 20

−0.5

0

0.5valeff tot & bond

time0 10 20

−0.5

0

0.5valeff equities & capital

time

agents receive on their capital stock in the home economy. Due to the expenditure-

switching effect, induced by the depreciation, demand for home products rises. As firms

are not free to adjust prices immediately, but instead are bound to satisfy higher demand,

they have to pay higher prices for their inputs, capital and labor. If the capital stock

which is used for the production of home goods, is owned in part by foreign households,

the latter will equally participate from the boom in demand. As a result, foreign real

income rises in such a situation and a manipulation of the exchange rate might even be

welfare reducing for the home economy.

27

Figure 4: Impulse Responses for positive international investment position in Bonds,FDI and Equities

0 10 20−0.5

0

0.5


0 10 200

0.2


0 10 20−2

0

2


0 10 20−1

−0.5

0

0.5terms of trade

0 10 20−0.01

−0.005

0ib, ib*

0 10 20−0.5

0

0.5


0 10 20−0.1

0


0 10 200

2

4


0 10 20−0.5

0

0.5


0 10 20−2

0

2

4FDI home & foreign

time0 10 20

−0.5

0

0.5

1valeff tot & bond

time0 10 20

−0.5

0

0.5valeff equities & capital

time

3.1.4 Bonds, FDI and Equities

In the final PCP setting, we consider a steady state where both countries have positive

international investment positions in all three categories available. Again, steady state

bond holdings of home households are assumed to amount to 100%, where assets (lia-

bilities) are in the foreign (home) currency denominated bond, and the capital stock in

each country is owned to 50% by home and foreign agents. In addition, home as well as

foreign households now own 50% of home and foreign equity in the steady state. The

resulting IR in response to a monetary shock are shown in Figure (4).

If international trade in all the three different categories — bonds, FDI and equities —

28

is considered, the revaluation effect of the depreciation becomes more important, as the

total amount of assets and liabilities in the steady state is higher. Furthermore, home

agents can benefit from the shared loss in domestic firms profits, which is distributed

between home and foreign agents according to the relative share of firm equities. Thus,

foreign agents loose twice on their shares of home firms, once in terms of value and once

in terms of lower dividends. As a result, the increase in foreign consumption is again

low. Notice that this result is due to the assumption of sticky prices, while wages are

assumed to be flexible. Yet, if wages could not adjust immediately, this effect would be

mainly borne by home agents, and foreign agents might even benefit from the boom in

demand.15 However, this feature is not yet included in the model.

3.2 Local Currency Pricing

In this section, we investigate the impact of the alternative international investment

positions in the steady state on the effects of a monetary policy shock for the assumption

of local-currency pricing.

3.2.1 Benchmark LCP

Figure (5) displays the results for the benchmark set-up with no positive international

investment in the steady state. As can be seen from the impulse responses, for the

assumption of LCP, the expenditure-switching effect vanishes, and the rise in home

demand is directed towards both home and foreign goods proportionately. Thus, the

increase in demand for foreign products is lower because of the home bias. Compared

with the situation in Figure (1), foreign income hardly rises even though foreign produc-

tion increases. This effect is due to the deterioration of the terms of trade, lowering the

foreign currency value of exports to the home country. As a result, foreign consumption

does not rise, and foreign households will be worse off. Initially, the home country runs

15Tille (2005) finds this risk-sharing property of equities. Notice, however, that in his two-periodmodel, labor is the only input factor. Hence, as long as wages are fixed, marginal costs do not rise andhome firms’ profits will increase in response to higher demand.

29

Figure 5: Impulse Responses for the Benchmark LCP scenario without any positiveinternational investment position in the steady state

0 10 20−0.5

0

0.5


0 10 20−0.5

0


0 10 20−2

0

2


0 10 20−0.5

0

0.5

1terms of trade

0 10 20−10

−5

0

5x 10

−3 ib, ib*

0 10 200

0.5

1


0 10 20−20

−10

0

10profits h and f

0 10 20−0.2

0


0 10 20−0.5

0

0.5


time

0 10 20−1

0

1valeff

time

a current account deficit for consumption purposes and in order to finance increasing

investment in the home capital stock. However, the current account will eventually turn

into surplus, and the net foreign asset position of the home economy will improve. Again,

with no initial international investment position, no valuation effect occurs.

3.2.2 Bonds only, LCP

This is different, if non-zero gross international asset positions are considered in the

steady state. The resulting impulse responses for the bonds-only scenario are depicted

in Figure (6). Again, the depreciation increases the home country’s net foreign asset

30

Figure 6: Impulse responses for B=100%, LCP

0 10 20−0.5

0

0.5


0 10 20−0.5

0


0 10 20−2

0

2


0 10 20−0.5

0

0.5

1terms of trade

0 10 20−10

−5

0

5x 10

−3 ib, ib*

0 10 200

0.5


0 10 20−20

−10

0

10profits h and f

0 10 20−1

0

1


0 10 20−0.5

0

0.5


time

0 10 20−0.5

0

0.5valeff

time

position, and home currency earnings on foreign bonds further raise the increase in real

home income. Thus, the valuation effect for bonds is not affected by the price setting

behavior of firms.

3.2.3 FDI only, LCP

Figure (7) depicts the resulting impulse responses for the assumption of 50% cross-

country capital ownership in the steady state. Recall that for the assumption of PCP,

foreign households were able to participate in the boom in demand for home goods

induced by a monetary expansion in the home country, as long as they own a part of the

capital stock used for production in the home country. However, for the assumption of

31

Figure 7: Impulse Responses for Foreign Direct Investment, LCP

0 10 20−0.5

0

0.5


0 10 20−0.5

0


0 10 20−2

0

2


0 10 20−0.5

0

0.5

1terms of trade

0 10 20−10

−5

0

5x 10

−3 ib, ib*

0 10 200

0.5

1


0 10 20−0.1

0


0 10 20−2

0

2


0 10 20−0.5

0

0.5


0 10 20−2

0

2

4FDI home & foreign

time0 10 20

−0.5

0

0.5

1valeff tot & bond

time0 10 20

−0.5

0

0.5

1valeff equities & capital

time

LCP, the expenditure-switching effect vanishes, and the rise in home demand is directed

towards both home and foreign goods proportionately. Thus, compared to Figure (3), the

risk-sharing property of FDI is less important in such a situation. As the redistributional

channel of the exchange rate change remains active, a welfare enhancing effect for home

agents in response to an expansionary monetary shock becomes much more likely.

3.2.4 Bonds, FDI and Equities, LCP

The corresponding result also holds, if non-zero gross international investment positions

are considered in all three categories, as shown in Figure (8). Again, the risk-sharing

32

Figure 8: Impulse Responses for positive international investment position in Bonds,FDI and Equities, LCP

0 10 20−0.5

0

0.5


0 10 20−0.5

0


0 10 20−2

0

2


0 10 20−0.5

0

0.5

1terms of trade

0 10 20−10

−5

0

5x 10

−3 ib, ib*

0 10 200

0.5


0 10 20−0.1

0


0 10 200

2

4


0 10 20−0.5

0

0.5


0 10 20−2

0

2

4FDI home & foreign

time0 10 20

−0.5

0

0.5

1valeff tot & bond

time0 10 20

−0.5

0

0.5

1valeff equities & capital

time

property of FDI is reduced. Note, that for the assumption of flexible wages and sticky

prices, the abolition of the expenditure-switching effect induces a redistribution of profit

declines. Whereas home profits still fall (albeit by less than compared to Figure (4)),

foreign firms’ profits decline as well, as production in the foreign economy rises. Thus,

compared to the PCP scenario, the endured losses of foreign households due to foreign

equity holdings are smaller. However, the overall effect on real income appears to be

small.

33

4 Conclusion

In this paper, we investigate the implications of increasing international financial inte-

gration, experienced in most industrialized countries during the past two decades, on the

effects of monetary policy. It was shown, that the existence of large amounts of foreign

assets and liabilities opens up a second transmission channel for monetary policy in an

open economy in addition to the trade channel. This has several implications: First,

the value of foreign currency denominated assets and liabilities will vary proportion-

ately with exchange rate changes. Second, asset prices such as equity prices might also

be affected directly by monetary policy, also resulting in corresponding revaluations of

international investment positions. Finally, domestic currency returns on foreign assets

will also vary with exchange rate changes, but might also be affected directly by the

consequences of the monetary policy shock. The main contribution of this paper is that

we include three different types of international financial integration — trade in bonds,

equities as well as FDI — jointly in a two-country DSGE model with sticky prices. Due

to the increasing importance of FDI and equities, and the underlying higher variance

of their returns, allowing for non-zero international investment positions in these two

categories seems to be an important feature of a model that aims at understanding the

consequences of financial globalization.

We find that in the current specification without sticky wages, the manipulation of

the exchange rate is more favorable for a country, the more its inhabitants own foreign

bonds and equities, the less foreign owned capital is used in the home production process

and the more firms are likely to price-discriminate between the two markets. This result

is due to the risk-sharing properties of FDI. In response to a monetary expansion in the

home country, demand for home goods increases, which raises returns on home factor

inputs. As a result, returns on home capital owned by foreign households rise in foreign

currency despite the depreciation of the home currency, and foreign real income rises.16

Hence, the ownership of capital employed in the foreign production process can serve as16This is especially the case for the assumption of producer-currency price-setting behavior of firms.

34

an insurance against asymmetric demand but also against supply shocks. On the con-

trary, non-zero international investment positions in equities do not feature this property

in the current specification of the model. Note, however, that risk-sharing properties are

likely to emerge as soon as we allow for wage rigidities, which we intend to include

in a later version. Furthermore, to assess the incentive for a country to manipulate its

exchange rate via monetary policy, the resulting welfare implications also need to be

computed, and a sensitivity analysis needs to be conducted.

35

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