Composition of Foreign Assets: The. Valuation-Effect and Monetary Policy

Transcription

1 Composiion of Foreign Asses: The Valuaion-Effec and Moneary Policy Mahias Hoffmann and Caroline Schmid January 3s 7 Absrac Over he las wo decades, he globalizaion of financial markes has become an imporan feaure of he world economy. A remarkable characerisic of he increased gross capial posiions observed is ha for many indusrialized economies, mos of he liabiliies are denominaed in he counries own currency while heir asses are mainly held in foreign currencies. Consequenly, a depreciaion of heir currency booss he domesic currency value of heir asse posiion relaive o he currency value of heir liabiliies, improving he ne foreign asse posiion of he counry. However, valuaion effecs may also be due o oher price changes, e.g. changes in asse prices or he value of FDI. Besides he impac on he value of asses and liabiliies, an exchange rae change induced by moneary policy will also aler he domesic currency reurns on foreign asses. Ye, he laer may as well be affeced by variaions in he underlying reurns. The conribuion of his paper is o accoun for he variey of implicaions due o increased financial inegraion by allowing for all hree possible inernaional linkages rade in bonds and equiies across counries as well as FDI joinly. In a wo-counry DSGE model Universiy of Cologne, Deparmen of Economics, Alberus-Magnus-Plaz, 593 Cologne, Germany, m.hoffmann@wiso.uni-koeln.de Caroline Schmid, Konjunkurforschungsselle der ETH Zürich, ETH Zenrum WEH, CH-89 Zürich, Swizerland, Phone: , Fax: , schmid@kof.gess.ehz.ch.

2 wih sicky prices and alernaive posiive inernaional invesmen posiions in he seady sae, we show ha he wealh-enhancing redisribuional effec of a depreciaion in response o a moneary expansion faces a couner weigh when FDI is incorporaed. Wih FDI, foreign households can paricipae in he boom in demand for home goods as reurns on capial in he home counry increase. Thus, in such a siuaion a depreciaion of he currency is no longer necessarily welfare-improving for he home economy.

3 Inroducion Over he las wo decades he globalizaion of financial markes has become an imporan feaure of he world economy. The associaed surge in he mobiliy of inernaional capial has become increasingly imporan for indusrialized and indusrializing economies. IMFdaaindicaehagrosscapialflows beween indusrial counries rose by up o 3 percen compared o rade flows, which only increased by 63 percen. The increase in gross capial flows is accompanied by a greaer inerdependence beween naional economies. For example, US ownership of foreign porfolio equiy asses and bonds was below percen of GDP in he beginning of he 98s. In 3 he ownership in foreign equiy holdings (defined as foreign direc invesmen (FDI) plus porfolio equiy) increased o 4 percen of GDP. For oher counries, for example he Neherlands, foreign equiy holdings accoun for more han 5 percen of GDP. For Swizerland, gross foreign asses even amoun o almos 5 percen of GDP. On he oher hand, he main OECD counries foreign equiy liabiliies on average accoun for 6 percen of heir respecive GDP. A remarkable feaure of he increased gross capial flows is ha for mos indusrialized economies, mos of he liabiliy posiions are denominaed in he counries own currency while heir asse holdings are mainly in foreign currencies. Consequenly, a depreciaion of heir currency booss he domesic currency value of heir asse posiion relaive o he currency value of heir liabiliies, improving he ne foreign asse posiion of he counry. This valuaion effec is generaed by movemens in he nominal exchange rae. As a resul, exernal imbalances for example he hisorically high curren accoun defici of he US economy ogeher wih he worsening of is ne foreign asse posiion could make i desirable for a counry o manipulae is nominal exchange rae value o improve is ne foreign asse posiion. Cavallo and Tille (6) show for he US ha capial gains due o he depreciaion of he dollar during he period o 4 were See e.g. Lane and Milesi-Ferrei (3, 6b) as well as Tille (5) for more deails on he evoluion of inernaional financial linkages. 3

4 able o offse abou half of he US curren accoun defici. Reciprocally, Tille (3) showed ha he srenghening of he dollar during 999 o accouned for 3% of he decline in he ne inernaional invesmen posiion. Thus, besides increasing he porfolio reurn on foreign asse holdings, a depreciaion of he domesic currency resuls in a wealh ransfer o he domesic economy. However, valuaion effecs may also be due o oher price changes, e.g. changes in asse prices or he value of FDI. Furhermore, besides he impac on he value of asses and liabiliies, an exchange rae change induced by moneary policy will also aler he domesic currency reurns on foreign asses. 3 Ye,helaermayaswellbeaffeced by variaions in he underlying reurns. The conribuion of his paper is o accoun for he variey of implicaions due o increased financial inegraion by allowing for all hree possible inernaional linkages rade in bonds and equiies across counries as well as FDI joinly. As shown by Lane and Milesi-Ferrei (5a), his exension is also of empirical relevance, as he relaive imporance of boh FDI and porfolio equiy in he foreign asse and liabiliy posiions has increased during he pas years. Given he examples above and he diversified srucure of he foreign porfolio holdings across counries, i will be analyzed under which condiions i migh be desirable for a counry o manipulae he nominal exchange rae o improve is welfare. How imporan is he composiion of he foreign porfolio posiion for he resuls? Is here a role for moneary policy o govern he nominal exchange rae behavior? Wha are he spillover effecs of such a policy for oher counries and wha could be he consequences for overall macroeconomic sabiliy if one counry makes use of he valuaion effec o increase is ne foreign asse posiion? In his paper we address hese quesions by means of a wo-counry DSGE model wih price-rigidiies and capial accumulaion, where we incorporae a diversified foreign asse porfolio of counries. More precisely, he financial marke srucure allows for rade Corresponding resuls are also shown in Abora (4) and in Lane and Milesi-Ferrei (5b). 3 For an empirical invesigaion on reurn differenials see Lane and Milesi-Ferrei (5b). 4

5 in bonds and in porfolio equiies across counries as well as for foreign direc invesmen (FDI). Alhough here are a number of auhors which have looked a valuaion effecs in hese models (see for insance Ghironi, Lee and Rebucci (5), Tille (5) and Cavallo and Tille (6)), o our knowledge none of hese approaches has ye incorporaed all hree ypes of inernaional financial linkages joinly (in paricular no FDI). I will be shown ha especially he laer proves o be imporan for our resuls. 4 In he model derived, he world is assumed o consis of wo equal-sized counries, each inhabied by a coninuum of represenaive agens as well as of a coninuum of monopolisic firms, each producing a differeniaed good wih he wo available facors labor and capial. Agens can rade wo inernaionally raded riskless bonds as well as home and foreign equiies (i.e. shares of home and foreign firms). Besides, agens can accumulae capial abroad via foreign direc invesmen. The laer wo assumpions allow for wealh and income effecs in addiion o he pure valuaion effec in response o an exchange rae change. I will be shown ha under cerain circumsances (i.e. producercurrency pricing), hese effecs can be more imporan han he pure redisribuional effec caused by he change in he exchange rae. Even hough he model is log-linearized around a symmeric seady sae where each counry s ne foreign asse posiion is zero, gross inernaional invesmen posiions ha differ from zero are allowed. In he following, he effecs of a permanen expansionary moneary policy shock in he home counry are simulaed and analyzed, where we consider differen inernaional invesmen scenarios for wo alernaive price-seing assumpions, producer-currency pricing (PCP) and local-currency pricing (LCP). The main resuls are he following: As long as he redisribuional effec of an exchange rae change dominaes, a depreciaion of he home currency raises he ne foreign asse posiion (and hus welfare) of a counry which is indebed in is own currency and holds foreign asses denoed in 4 Noice ha here are wo facors of producion in our model and we absrac from sicky-wages in he curren seing. Hence, as demand goes up and firms canno adjus prices, profis decline. As a resul, rade in equiies does no have he same risk-sharing properies as in Tille (5), where labor is he only inpu and he considers wage-rigidiies in addiion o price rigidiies. Ye, we inend o include hese feaures in a laer version. 5

6 he foreign currency. As an exchange rae change represens a zero-sum siuaion, he foreign counry, on he oher hand, is always worse off compared o a siuaion wih no foreign porfolio posiion. Wihforeignbondholdings, hiseffec is he dominan effec, independen of he price-seing behavior of firms, which can eiher be PCP or LCP. 5 Besides he exchange rae change, he value of foreign equiies is also affeced by asse price changes which will vary wih expeced profis. In our simulaions, in addiion o he exchange-rae effec relaive foreign equiy prices rise, which increases he redisribuion of wealh from foreign o home households in response o a moneary expansion. 6 Ye, his does no hold wih respec o foreign direc invesmen. Even hough in he seing wih FDI only, he exchange-rae effec is sill a work, a differen channel of redisribuion emerges, as reurns on FDI vary wih variaions in aggregae demand for foreign producs. Hence, wih complee PCP, a high exposure o FDI induces an effec in he opposie direcion. Due o he expendiure-swiching effec, induced by he depreciaion, demand for home producs rise. As firms are no free o adjus prices immediaely, bu insead are bound o saisfy higher demand, hey will have o pay higher prices for heir inpus, capial and labor. If he capial sock, which is used for he producion of home goods, is owned in par by foreign households, he laer will equally paricipae from he boom in demand. Depending on he relaive size of foreign bond exposure and he variabiliy of reurns on FDI, his effec migh even more han compensae he exchange-rae effec. In his case, he foreign counry migh benefifrom a depreciaion of he home currency. However, his is no rue for complee LCP. As in his case impor prices (and hus relaive prices) are no longer affeced by a depreciaion of he exchange rae, demand increases for boh home and foreign goods proporionaely. As a resul, he risk-sharing propery of FDI is less imporan in such a siuaion. 5 Besides he redisribuion of wealh, he depreciaion also raises reurns of home households on heir bonds denominaed in he foreign currency, increasing curren income. 6 The shor-run income effec works again in he same direcion as dividends on home equiies fall due o a decline in home firms profis, reducing foreign households real income. 6

7 Hence, in his paper we show ha he wealh- and welfare-enhancing effecs of a depreciaion of he home currency face a counerbalance when FDI is incorporaed in his ype of model. Wih FDI, foreign households can paricipae in he boom in demand for home goods induced by a moneary expansion, and he risk of demand shocks is shared beween home and foreign agens. Thus, in such a siuaion a depreciaion of he home currency is no longer necessarily welfare-improving for he home counry. The srucure of he paper is as follows. In he nex secion, he model is derived and he srucure of inernaional financial inegraion is described in deail. Secion 3 presens he resuls. For illusraional purposes, he impulse response funcions for he relevan home and foreign variables in response o a single permanen % increase in home money supply are presened and discussed for a number of seings where we invesigae differen inernaional invesmen posiions in he seady sae as well as alernaive price-seing sraegies. Secion 4 hen concludes. The Model In he following, a wo-counry dynamic general equilibrium model wih nominal price rigidiies in he radiion of he New Open Economy Macroeconomics is derived. The world is assumed o consis of wo counries, home and foreign, each inhabied by a coninuum of agens normalized o. Agens consume consumpion goods, supply labor and accumulae capial which hey ren ou o firms. A coninuum of individual monopolisic firms resides in he home and he foreign counry, which are respecively indexed by z h [, ] and z f [, ]. Eachfirm produces a single differeniaed good, whereas labor and capial in each counry are assumed o be homogenous and can be subsiued across firms wihin one counry wihou any cos. To disinguish foreign from home agens, he foreign variables will be idenified wih an aserisk. 7

8 . Individual preferences and prices Preferences of he represenaive Home agen i are given by he following uiliy funcion " X U = E β s s= C σ s σ + χ µ Ms P s + η ln ( L s )# () The ineremporal elasiciy of subsiuion beween consumpion oday and omorrow is given by. The parameer η can be seen as a shif parameer in he marginal uiliy of σ leisure. The shif parameer in money demand is refleced by χ and he ineres elasiciy of money demand is given by β. Real balances are equal o M. The home consumer price P index a ime is derived as P = λ P h µ µ +( λ) ³P f µ, () where µ reflecs he parameer of he elasiciy of subsiuion beween home and foreign goods and λ denoes he degree of home bias in consumpion. The price indices for he composie goods are defined as P h = Z p h z h θ dz h θ (3) P f, he home price index for impored goods from he foreign counry, is correspondingly defined as a weighed average of he home currency price of each foreign good variey z f. The consumpion index of he home counry can be wrien as follows: C = µ λ µ ³ µ C h µ +( λ) µ C f µ µ µ µ, (4) wih C h = Z c h z h θ θ dz h θ θ, C f = Z c f z f θ θ dz f θ θ. (5) 8

9 The elasiciy of subsiuion beween any wo heerogeneous goods is refleced by θ>. The condiional commodiy demand funcions in he home and foreign counry are derived by minimizing he expendiure for he composie goods z and are given by c h c f z h = λ Ã p h z h P h z f = ( λ) Ã p f! θ µ P h z f P f P µ C, (6)! θ Ã P f P! µ C. (7) Similar resuls hold for he foreign economy.. Asse Allocaion The main conribuion of his paper is ha we allow for hree differen ypes of inernaional financial inegraion joinly. Firs, agens can inernaionally rade wo riskless bonds, one denominaed in he home and he oher in he foreign currency. Second, heymighpurchasesharesofbohhomeandforeignfirms. Finally, agens can also accumulaecapialinherespeciveforeigncounrywhichishenusedinheforeign producion process by foreign firms. In he following, he hree asse ypes in addiion o domesic money are described in more deail.. Inernaional Bonds Firs, agens can rade wo risk-free bonds B h and B f, where he former is denominaed in he home and he laer in he foreign currency. The bonds yield he nominal riskless ineres rae i and i beween period and, respecively, and are assumed o be perfec subsiues. Risk free bonds are in zero ne supply, hence: B h = B h (8) and B f = B f. (9) 9

10 .. Foreign Direc Invesmen Besides bonds, agens can also undergo foreign direc invesmen F (F ) o accumulae capialinherespeciveforeigncounrywhichishenusedinheforeignproducion process by foreign firms. Capial is assumed o depreciae a a consan rae δ and is subjec o adjusmen coss. The imporance of capial adjusmen coss is deermined by φ and φ, where he laer parameer accouns for he possibiliy ha capial adjusmen coss migh be more imporan for foreign direc invesmen, as he adminisraive and oher obsacles relaed o foreign direc invesmen migh be higher. The law of moion for he domesically and foreign owned capial sock available for producion in he home counry are K+ h = ( δ) K h + V φ ª K h + K h, K h n o () K f + = K f ( δ) K f + F φ + K f, () where V denoes invesmen of home agens in heir home capial sock and F K f denoes foreign direc invesmen in he home capial sock of foreign agens. For invesmen in he foreign capial sock, he law of moion akes he following form K+ h = ( δ) K h + F φ K f + = ( δ) K f + V φ ª K h + K h K h n K f + K f K f where F denoes foreign direc invesmen of home agens and V o, (). (3) denoes invesmen of foreign agens in heir own counry s capial sock. Absolue adjusmen coss are higher, ³ he higher he absolue change of he capial sock, K h K h and K f K f,andhe smaller he iniial capial socks. Capial is assumed o be homogenous bu is immobile beween counries. As a resul, for he producion process of firms, he ownership of he capial sock is irrelevan, and capial can be subsiued across firms wihin one

11 counry wihou cos. Each period, domesic and foreign agens ren heir exising capial sock in he home (foreign) counry o home (foreign) firms and receive he nominal ineres rae P r K (S P r k ) per uni. Hence, he nominal reurn on domesically owned capial in. he foreign counry amouns o S P ³ r k K h P r k K f S..3 Foreign Equiy Finally, each domesic (foreign) household can also purchase equiies in form of claims on weighed aggregae profis of home and foreign firms Π (Π ), refleced by Q H Q H and Q F Q F, respecively. 7 As equiies represen shares of home and foreign firms, he overall supply of home and foreign equiies is fixedandgivenby Q F = Q F + Q F (4) and Q H = Q H + Q H (5) The price for one uni of home equiy is q (³ q S ), he respecive price for a uni of foreign equiy is S q (q ), boh adjused by he nominal exchange rae S when he purchase occurs abroad. Whenever home (foreign) households like o adjus heir posiion in equiies hey need o accoun for equiy adjusmen coss, ϕ (Q H + QH ) Q H (Q F + QF (Q H + QH ) Q H and ϕ (Q F + QF ) ( ϕ and ϕ ) which are payable o he respecive governmen of Q H he counry where he equiy is issued. Disinc from capial adjusmen coss, equiy ) adjusmen coss are redisribued o home (foreign) agens as a lump-sum ransfer. Q H 7 We assume ha he firms profis are proporionally redisribued as dividends o he firms shareholders.

12 .3 Budge Consrain Taking he diversified porfolio srucure ino accoun, he home agen s budge consrain a ime hen becomes: µ P C + P V + S P F + M + S q Q F + Q F + ϕ Q F + Q F Q F +q Q H + Q H µ + ϕ Q H + Q H Q H = W L + M + P r k K h + S P r k K h + + B+ h + S B f + Π S Q F QF + Π Q H QH (6) +(+i ) B h + S ( + i ) B f + P τ Thus, each period, he household allocaes resources beween consumpion P C,nominal balances, M, home and foreign bonds B+ h + S B+, f home and foreign equiies, ³ ³ q Q H + Q H + ϕ and S q Q F + Q F + ϕ, and domesic Q H + QH Q H Q F + QF Q F as well as foreign direc invesmen, P V and S P F. The resources of he household consis of redisribued profis on home and foreign firm shares, Π Q H Q H and S Π Q F Q F, nominal wage income W L, he reurn on invesmen in he domesic and foreign capial sock, P r k K h and S P r k K h, he reurns on bonds, ( + i ) B h and S ( + i ) B f, a lump-sum ransfer by he governmen, P τ, and he cash holdings M from he previous period. Themaximizaionofheobjecivefuncion()subjecohebudgeconsrain(6) leads o he following firs order condiions: C σ = βe M P = W P = C σ +( + i + ) P P {z + } (+r + ) µ χc σ E µ ( + i+ ) η C σ ( L ) i + (7) (8) (9)

13 The firs opimaliy condiion (7) is he Euler equaion which deermines he opimal ineremporal consumpion pah. The higher he expeced home real ineres rae r +, he higher he opporuniy cos for consumpion oday, and he more he household will be inclined o pospone consumpion o he nex period. Money demand is shown in equaion (8). The demand for real money balances is increasing in real consumpion expendiures and declines wih an increase in he nominal ineres rae as he opporuniy cos of holding he non-ineres bearing asse rises. The hird opimaliy condiion (9) deermines he opimal labor supply, which is increasing in he real wage and decreasing in consumpion. Hence, households supply labour o he poin where he marginal disuiliy of labour equals is marginal benefi. The opimal porfolio choice beween home and foreign bonds implies ha C σ + ( + i + ) E P + = C σ +i + + E P + µ S+ S. () Equaion () reflecs he opimal choice beween home and foreign bonds, which for he assumpion of cerainy equivalence employed below resuls in he uncovered ineres rae pariy, ( + i ) E(S +) S =(+i ). The opimal porfolio choices wih respec o equiies and capial are deermined by aking adjusmen coss and he law of moion for he capial sock () and () ino accoun and resul in he following opimaliy condiions for he invesmen in home and foreign equiies C σ q +ϕ QH + Q H P Q H C σ S q +ϕ QF + Q F P Q F " Ã C σ + = βe Ãq + + ϕ Q H + Q H!!# + P + Q H + Π + + Q H () Ã Ã "C + σ = βe S + q+ + ϕ Q F + Q F! + P + Q F + Π + + Q F ()!# 3

14 and for home and foreign direc invesmen µ+φ Kh + K h K h C σ P S P = βe " Ã P + S + +r+ K δ + φ K h + K h! + P + K h + µ "Ã +φ Kh + K h C σ K h = βe +r+ K δ + φ K h + K h! # + K h C+ σ + Equaion () reflecs he domesic household s opimal equiy invesmen decision. The cos due o forgone consumpion in order o increase oday s equiy holding by one uni (plus he marginal equiy adjusmen coss) has o equal he marginal income derived from he equiy holdings, which consiss of he increase in he equiies iself, he expeced dividend paymens, E ³ Π+ Q H, possible price changes q + plus he expeced decrease in equiy adjusmen coss. A similar relaionship holds for he purchase in foreign equiies, wih an explici role for he nominal exchange rae S. The household s opimal capial invesmen decisions are deermined by equaions (4) and (3). Similarly, for he household o be indifferen beween addiional invesmen in he home (foreign) capial sock and more consumpion, he cos borne in erms of forgone uiliy of consumpion in order o increase oday s home (foreign) capial sock by one uni has o be equal o he marginal o he marginal uiliy derived from he home (foreign) invesmen. The opimizaion of he foreign counry is similar o he home counry and resuls in he corresponding opimaliy condiions. (3) (4) C σ + #.4 Demand For simpliciy, we assume ha invesmen of home (foreign) agens in he capial sock of hehomeeconomy,v (F ), feaures he same composiion as he consumpion baske of home agens. The corresponding is rue for capial invesmen of foreign (home) agens in he foreign counry, V (F ). Thus, ogeher wih he consumpion demand derived in equaions (6) and (7) he overall demand for he represenaive home good by firm h 4

15 equaes o µ p y h h (h) = λ (h) P h +( λ) θ µ P h µ p h P (h) P h µ [C + V + F θ µ P h P ] µ [C + V + F ]. (5) A similar condiion holds for he foreign represenaive firm. Since all firms produce a differeniaed good, each firm faces an individual demand schedule which i akes as given when choosing is price o maximize profis. The profi maximizaion hen depends on he form of price rigidiies..5 Firms In an environmen of monopolisic compeiion, each firm will se is price so as o maximize expeced profis, aking is individual demand schedule, equaion (5), ino accoun. Price rigidiies à la Calvo (983) are included. 8 In order o analyze wheher he resuling effecs in response o a moneary shock for differen inernaional invesmen posiions in he seady sae are sensiive o differen price-seing sraegies, wo alernaive price-seing regimes are considered: producer-currency-pricing (PCP) and local-currency-pricing (LCP). 9 Whereas a PCP firm ses he price for is good in he domesic currency of he producer, independen of he marke where he good is sold, he LCP firm is assumed o se wo differen prices, one for he home marke and one for he foreign marke, each in he local currency of he marke. In he presence of shor-run price rigidiies, impor prices of PCP goods exhibi a complee exchange-rae pass-hrough while impor prices of LCP goods are no affeced by a change in he exchange rae. 8 Each firm faces he same consan probabiliy ( γ) every period o change is price nex period. 9 Bes and Devereux (,, 996), Engel () and Schmid (6) have shown ha he inernaional ransmission effecs of moneary policy shocks are crucially affeced by he way firms se heir prices. 5

16 .5. Profi maximizaion Profi maximizaion of he represenaive PCP firm In he presence of price rigidiies à la Calvo, firms se prices so as o maximize heir expeced discouned fuure profis, which are given by: E " X i= Ã! # e (γβ) i h,p CP P (h) Λ,+i MC +i h,p CP y,+i (h) P +i P +i wih Λ,+i = ³ C+i C σ. y h,p CP,+i (h) denoes he expeced oal demand of he represenaive home PCP firm a ime + i provided ha he price se a ime is sill effecive. The opimal price of he represenaive home PCP firm a ime, P e h,p CP (h),is hen derived as a markup over a weighed average of expeced fuure nominal marginal coss: h,p CP ep (h) = θ θ E h P i= (γβ)i Λ,+i D h,p CP,+i E h P i= (γβ)i Λ,+i D i MC +i i (6) h,p CP,+i h,p CP D,+i denoes oal expeced fuure real sales revenues of he PCP firm, given ha he opimal price chosen a ime is sill effecive. Since all PCP firms in he home counry face he same consrains, each firm ha can adjus is price in period will h,p CP choosehesameprice ep (h). The home counry price index for home PCP goods P h,p CP is hen a weighed average of las period s price index and he opimal price a ime : ³ h,p CP P = γ P h,p CP θ ³ θ θ +( γ) P e h,p CP (h) (7) Profi maximizaion of he represenaive LCP firm The represenaive LCP firm faces essenially he same opimizaion problem as he PCP firm, bu maximizes A noaional remark: The superscrip PCP idenifies goods produced and prices charged by PCP firms, he superscrip LCP marks he respecive variables for LCP firms. 6

17 profis arising from he home and he foreign marke, choosing wo differen prices: E " X i= à (γβ) i P e h,lcp Λ,+i +(γβ) i Λ,+i à P +i (h) MC +i P +i! y h,lcp,+i S +ip eh,lcp, (h) MC +i P +i P +i! (h) # y h,lcp,,+i (h) ep h,lcp, (h) denoes he opimal expor price of he represenaive home LCP firm se in he foreign currency,whichisconveredohehomecurrencyviaheexchangerae S +i. The quaniies y h,lcp,+i and y h,lcp,,+i denoe home and foreign agens demand for he represenaive home LCP good a + i given he prices e P h,lcp se a ime. (h) and P eh,lcp, (h) In he log-linearized version of he model, he opimal price in he domesic marke of he LCP firm is idenical o he PCP firm s price. This implies ha he home price index for domesically produced goods, defined in equaion(3) above, is simply wrien as: P h h,p CP = P (8) The opimal expor price ep h,lcp, (h) of he represenaive home LCP firm is derived as: MC +i S +i h P ep h,lcp, (h) = θ E i= (γβ)i Λ,+i D h,lcp,+i h θ P E i= (γβ)i Λ,+i D h,lcp,+i i i (9) As he LCP price for he foreign marke is se in he foreign currency, he opimal newly se price also depends on he expeced fuure pah of he nominal exchange rae, as he LCP firm akes ino accoun he increase in markup resuling from a devaluaion of he home currency. As expor prices of PCP and LCP firms differ, he price index of impored goods in he home economy is a weighed average of he average prices of foreignlcpandpcpgoodsp f,lcp and P f,pcp, argeed a he home marke. The respecive weighs are deermined by he share of LCP firms, s. Therefore, he home 7

18 price index of impored foreign goods simplifies o: ³ P f = s P f,lcp θ +( s) ³ S P f,pcp, θ θ (3).5. Producion The paper aims a exploring he consequences of inernaional capial and financial inegraion. Therefore, we inroduced foreign direc invesmen, i.e. home agens can also accumulae capial in he foreign counry and vice versa. As a resul, he overall capial sock available for producion in he home counry consiss of capial owned by domesic, K h, and foreign residens, K f, and can be specified by K = K h + K f. (3) Producion in each counry hen akes place ou of accumulaed domesic and foreign direc invesmen. In he foreign economy, he capial sock available for foreign firms correspondingly consiss of capial owned by foreign as well as by home agens. Thus, a similar condiion, K = K f + K h, (3) is valid. Firms a home and abroad produce under consan-reurns-o-scale, employing he following Cobb-Douglas producion funcion y (h) =A K (h) α L (h) α,displayed for he example of he represenaive home firm h. A represens he common level of echnology in he home counry, while K (h) and L (h) denoe he individual capial and labor inpus of he represenaive home firm h. Cos minimizaion implies ha firms will demand facor inpus o saisfy he wage rae, W = MC ( α) yh (h) L (h) = MC ( α) yh L, (33) 8

19 and he nominal ineres rae P r K = MC α yh (h) K (h) = MC α yh K. (34) MC denoes he nominal marginal coss of producion. Since all firms in one counry have o pay he same wage and face he same renal rae for capial, marginal coss are he same across all firms residing in one counry. A similar condiion is rue for he foreign counry..6 The Consolidaed Budge Consrain For simpliciy, i is assumed ha all seignorage revenue accruing o he cenral bank as well as he equiy adjusmen coss received by he governmen are redisribued o he households in form of a lump-sum ransfer. Hence, he home counry s governmens budge consrain equaes o P τ = M M + ϕ S q Q F + Q F Q F + ϕ q Q H + Q H Q H (35) Taking he lump-sum redisribuion of seignorage and equiies adjusmen coss ino accoun, he consolidaed budge consrain of he home economy (6) reduces o P C + P V + S P F + S q Q F + Q F + q Q H + Q H = W L + P r k K h + S P r k K h + S Π Q F QF + Π Q H QH + B h + + S B f + (36) +(+i ) B h + S ( + i ) B f.7 Curren Accoun and Ne Foreign Asses The curren accoun can be wrien in erms of inernaional financial flows as CA = S q Q F + Q F + q Q H + Q H + ³ B+ h B h + S B f + B f + S P F P F, (37) 9

20 Employing he consolidaed budge consrain derived in equaion (36), he curren accoun can hen also be expressed as CA = W L +P r k K h +S P r k K h + S Π Q F QF + Π Q H QH +i B h +S i B f P C P V P F By definiion, he curren accoun measures financial flows which affec he ne foreign asse posiion of counries. Ye, he laer is also affeced capial gains and losses due o exchange rae and price changes. Taking hese valuaion effecs ino accoun, he change of he ne foreign asse posiion can be expressed as NFA + NFA = CA S P " δk h + φ K h + K h K h ª # + P δk f + φ n K f + K f K f o (38) +B f (S S )+ S q S q Q F +(q q ) Q H +K h S P S P K f (P P ). The valuaion effecs - measured in he domesic currency - consis of revaluing foreign bonds, home and foreign equiies as well as home and foreign capial because of price and exchange rae changes. Noe ha we also subrac capial depreciaion and adjusmen coss from he change in ne foreign asses, as capial adjusmen coss due o FDI do no raise he foreign asse posiion (alhough hey are included in he curren accoun measure) while capial depreciaion reduces i. Hence, he changes in he ne foreign asse posiion are driven by he curren accoun and valuaion changes, which originae from changes in he asse prices in conjuncion wih he exchange rae..8 Marke Clearing Condiions In equilibrium, all goods, facor and asse markes need o clear in he home and he foreign economy. In he home goods marke, aggregaed demand consiss of demand for LCP and PCP goods: Y h = sy h,lcp h,p CP +( s) Y (39)

21 Since all home firms produce wih he same capial-labor raio, oal supply in he home counry can be wrien as: Y h = Z A K α z h H α z h dz h = A K α H α (4) The foreign goods marke clears analogously. The home (foreign) money marke is in equilibrium if naional money demand corresponds o he exogenous supply of home (foreign) currency provided by he naional cenral bank. Bond markes clear in equilibrium if home and foreign bonds are in zero ne supply worldwide as described in equaions (8) and (9). By he same oken, equiy markes clear if home and foreign equiy are in zero ne supply, i.e. equaions (4) and (5) hold. For facor markes o clear, oal demand for capial and labor of home (foreign) firms resuling from producion decisions derived in equaions (33) and (34) have o equal capial and labor supplied in hehome(foreign)counry,k and L (K and L )..9 Equilibrium Equilibrium is characerized by equaions (), (), (), (7), (8), (9), (), (), (4), (3), (8), (6), (9), (3), (33), (34), (36), (39), (4), and heir foreign counerpars, demand equaion (5) and average price equaion (7) for boh LCP and PCP goods in he home and he foreign economy, as well as equaions () and he bonds and equiies marke equilibria (8), (9), (5) and (4) which gives 5 equaions. This is a dynamic sysem in he following hiry-nine variables, given by: X = {C,C,L,L,V,V,F,F,K h,k h,k f,k f,q H,Q H,Q F,Q F, W,W,r k,r k,i,i,q,q,mc,mc,s,b h,b h,b f,b f, P,P,P h,p f P h,lcp,p f,pcp,p h,p f, e P h,p CP,P f,lcp,y h,y f, e P h,lcp,,y h,p CP, e P f,pcp,y h,lcp, e P f,lcp h,p CP,P,,Y f,pcp,y f,lcp }

22 The model is solved by linearizing around a symmeric seady sae, where he ne foreignasseposiionofbohcounriesiszero. However, we allow for differen degrees of inernaional financial inegraion in he seady sae, i.e. posiive gross asse and liabiliy holdings.. Calibraion The calibraed parameers are presened in Table. The quarerly real ineres rae is se o % in he seady sae. The consumpion elasiciy of money demand ( σ in he model) is commonly esimaed o be abou uniy, see, e.g., Mankiw and Summer (986), which is he value we adop. For he ineres elasiciy of money demand ( β in he model), he esimaes vary from.39 in Chari e al. () o.5 in Mankiw and Summers (986). For he benchmark calibraion, we choose.39. The benchmark values for money demand elasiciies imply ha σ is abou.5. The parameer θ deermines he markup of prices over marginal coss. Consisen wih he findings of Basu and Kimball (997), which sugges a markup of abou % in he U.S., we assume θ =.The capial share α is se o. This value is in line wih empirical evidence on he labor 3 share provided by Benolila and Sain-Paul (3), which is found o range from 6% o 68% for he G-7 counries in he 99s. The rae of depreciaion δ is se o., which implies an annual depreciaion rae of abou %, corresponding o he ypical esimaes for U.S. daa. The seady sae share of labour, H, is se o.3. For simpliciy, he relaive preference parameer for real balances, χ, is assumed o be. The las wo assumpions furher deermine η, he preference parameer for leisure, o be.8. The price adjusmen parameer is se such ha he average ime beween price adjusmen for a firm is one year. This implies γ =.75. The impor share in he seady sae is assumed o be 5% for boh counries. While he U.S. average impor share in he pos For he soluion of he model, he MATLAB code provided by Schmi-Grohé and Uribe (4) is employed. Boh Chari e al. and Mankiw and Summers use consumpion as he relevan quaniy variable for he esimaion of money demand elasiciies, which corresponds o he seup in he model. Chari e al. () also implicily assume a uniy consumpion elasiciy of money demand in heir regression.

23 Breon Woods era amouns o abou %, impor shares in he remaining G-7 counries during his ime period range from % in Japan o almos 3% in Canada. The value for capial adjusmen coss φ is se o 8, which induces an invesmen response o an unanicipaed increase in home money supply for he baseline calibraion of abou 3 imes he size of he corresponding oupu response in he home counry, and hus corresponds o he findings of he VAR analysis. Equiy adjusmen coss are needed in order for equiy demand o be deermined. Ye, o keep he disorion small, he adjusmen cos parameer ϕ is se o.. Finally, he elasiciy of subsiuion beween home and foreign goods µ is se equal o.5 as found by Hooper and Marquez (995, Table 4.) for he U.S. The degree of pricing o marke s is eiher se o or. Table : Calibraed parameers σ.5 χ θ.5 δ. µ.5 φ 8 β ϕ.. η.8 α γ Resuls In he following, he effecs of a % permanen increase in home money supply are simulaed and analyzed for eigh differen alernaive scenarios, where we consider four differen inernaional invesmen scenarios for wo alernaive price-seing assumpions. For each of he wo pricing assumpions of firms, local-currency pricing (LCP) and producer-currency pricing (PCP), we consider a benchmark scenario wih no posiive inernaional invesmen posiion in he seady sae. 3 Second, we invesigae he case where in he seady sae, only inernaional bond holdings occur. In he hird scenario, we look a he effecs of moneary policy shocks for he exisence of posiive invesmen posiion in he seady sae of FDI only. In he las scenario, we consider posiive inernaional invesmen posiions in bonds, equiies and FDI joinly. 3 Noice, however, ha households are allowed o rade bonds in response o shocks. 3

24 The ploed impulse responses (IR) are percenage deviaions from respecive seadysae values, excep for he ineres raes, he curren accoun and ne foreign asses. For he ineres raes, he deviaions depiced are in percenage-poins, while he curren accoun and he ne foreign asse posiion is defined in percen of seady-sae home nominal income. Solid (dashed) lines show he responses of he firs (second) variable. The horizonal axes depic he number of quarers. 3. Producer Currency Pricing 3.. Benchmark PCP Figure () displays he IR for he benchmark scenario wih complee PCP obained for a % permanen increase in home money supply. As can be seen, a moneary policy shock in he home counry raises home and foreign consumpion and invesmen. Ye, due o he expendiure-swiching effec, only home producion increases whereas foreign producion remains almos unchanged. Ye, due o he deerioraion of he erms of rade, foreign real income increases. A he same ime, he home economy runs a curren accoun surplus. In erms of welfare, he foreign counry benefis from he increase in consumpion, whereas home agens also have o supply more labor, resuling only in a small increase in uiliy. 4 Wih no posiive inernaional invesmen posiion in he seady sae, no valuaion effec emerges and he ne foreign asse posiion is solely driven by capial flows, i.e. cumulaed curren accoun surpluses. 3.. Bonds only In he bonds-only scenario, he home counry owns foreign currency denominaed bonds amouning o % of home nominal GDP in he seady sae. A he same ime, i has liabiliies of he same order in he home currency bond. Hence, he ne foreign asse posiion is again zero, bu he inernaional invesmen posiion is posiive in he seady sae, and a valuaion effec in response o exchange rae changes will occur. Figure () 4 See Schmid (6) for his resul. 4

25 Figure : Impulse Responses for he Benchmark PCP scenario wihou any posiive inernaional invesmen posiion in he seady sae oupu: home, foreign consumpion: home, foreign.4 dom. invesmen: home, foreign erms of rade.5 profis h and f valeff.5 ib, ib*. curren accoun, NFA.4. nom. and real exch. rae.5.5 real income h and f.5.5 ime ime displays he corresponding resuls in response o a % increase in home money supply. For he bonds-only scenario, a depreciaion of he home currency raises he ne foreign asse posiion of he home counry as he home currency value of foreign currency denominaed asses rises. Hence, in his case he exchange rae change redisribues wealh from he foreign o he home counry. A he same ime, he ineres paymens on foreign asses convered o home currency increase due o he depreciaion. As a resul, foreign consumpion is lower compared wih he benchmark scenario and he foreign counry is worse off while home counry s siuaion improves compared o a siuaion wih no inernaional invesmen posiion. 5

26 Figure : Impulse responses for B=%, PCP oupu: home, foreign consumpion: home, foreign.4 dom. invesmen: home, foreign 4.5. erms of rade.5.5 profis h and f valeff..5 ib, ib*. curren accoun, NFA.5.5 nom. and real exch. rae.5.5 real income h and f.5.5 ime. ime 3..3 FDI only In he hird scenario, we invesigae a seady sae where boh home and foreign households each own half of he capial sock in he home and he foreign counry. The corresponding impulse responses are depiced in Figure (3). If FDI is he only inernaional invesmen posiion in he seady sae, a differen channel of redisribuion emerges, as reurns on FDI vary wih variaions in aggregae demand for foreign producs. Alhough he value of he capial sock in he foreign counry owned by home agens increases in erms of home currency as before, afer a couple of periods his effec is more han offse by he increase in reurns which foreign 6

27 Figure 3: Impulse Responses for Foreign Direc Invesmen, PCP oupu: home, foreign consumpion: home, foreign.4 dom. invesmen: home, foreign erms of rade.5 profis h and f firms.. FDI home & foreign 4 ime.5 ib, ib*. curren accoun, NFA 4 valeff o & bond.5.5 ime nom. and real exch. rae.5.5 real income h and f.5.5 valeff equiies & capial.5.5 ime agens receive on heir capial sock in he home economy. Due o he expendiureswiching effec, induced by he depreciaion, demand for home producs rises. As firms are no free o adjus prices immediaely, bu insead are bound o saisfy higher demand, hey have o pay higher prices for heir inpus, capial and labor. If he capial sock which is used for he producion of home goods, is owned in par by foreign households, he laer will equally paricipae from he boom in demand. As a resul, foreign real income rises in such a siuaion and a manipulaion of he exchange rae migh even be welfarereducingforhehomeeconomy. 7

28 Figure 4: Impulse Responses for posiive inernaional invesmen posiion in Bonds, FDI and Equiies oupu: home, foreign consumpion: home, foreign.4 dom. invesmen: home, foreign erms of rade.5.5 profis h and f firms.. FDI home & foreign 4 ime.5 ib, ib*. curren accoun, NFA 6 4 valeff o & bond.5.5 ime nom. and real exch. rae.5.5 real income h and f.5.5 valeff equiies & capial.5.5 ime 3..4 Bonds, FDI and Equiies In he final PCP seing, we consider a seady sae where boh counries have posiive inernaional invesmen posiions in all hree caegories available. Again, seady sae bond holdings of home households are assumed o amoun o %, where asses (liabiliies) are in he foreign (home) currency denominaed bond, and he capial sock in each counry is owned o 5% by home and foreign agens. In addiion, home as well as foreign households now own 5% of home and foreign equiy in he seady sae. The resuling IR in response o a moneary shock are shown in Figure (4). If inernaional rade in all he hree differen caegories bonds, FDI and equiies 8

29 is considered, he revaluaion effec of he depreciaion becomes more imporan, as he oal amoun of asses and liabiliies in he seady sae is higher. Furhermore, home agens can benefi from he shared loss in domesic firms profis, which is disribued beween home and foreign agens according o he relaive share of firm equiies. Thus, foreign agens loose wice on heir shares of home firms, once in erms of value and once in erms of lower dividends. As a resul, he increase in foreign consumpion is again low. Noice ha his resul is due o he assumpion of sicky prices, while wages are assumed o be flexible. Ye, if wages could no adjus immediaely, his effec would be mainly borne by home agens, and foreign agens migh even benefi fromheboomin demand. 5 However, his feaure is no ye included in he model. 3. Local Currency Pricing In his secion, we invesigae he impac of he alernaive inernaional invesmen posiions in he seady sae on he effecs of a moneary policy shock for he assumpion of local-currency pricing. 3.. Benchmark LCP Figure (5) displays he resuls for he benchmark se-up wih no posiive inernaional invesmen in he seady sae. As can be seen from he impulse responses, for he assumpion of LCP, he expendiure-swiching effec vanishes, and he rise in home demand is direced owards boh home and foreign goods proporionaely. Thus, he increase in demand for foreign producs is lower because of he home bias. Compared wih he siuaion in Figure (), foreign income hardly rises even hough foreign producion increases. This effec is due o he deerioraion of he erms of rade, lowering he foreign currency value of expors o he home counry. As a resul, foreign consumpion does no rise, and foreign households will be worse off. Iniially, he home counry runs 5 Tille (5) finds his risk-sharing propery of equiies. Noice, however, ha in his wo-period model, labor is he only inpu facor. Hence, as long as wages are fixed, marginal coss do no rise and home firms profis will increase in response o higher demand. 9

30 Figure 5: Impulse Responses for he Benchmark LCP scenario wihou any posiive inernaional invesmen posiion in he seady sae oupu: home, foreign consumpion: home, foreign.5 dom. invesmen: home, foreign erms of rade.5.5 profis h and f valeff.5 5 x ib, ib* 3 5 curren accoun, NFA.. nom. and real exch. rae.5.5 real income h and f.5.5 ime ime a curren accoun defici for consumpion purposes and in order o finance increasing invesmen in he home capial sock. However, he curren accoun will evenually urn ino surplus, and he ne foreign asse posiion of he home economy will improve. Again, wih no iniial inernaional invesmen posiion, no valuaion effec occurs. 3.. Bonds only, LCP This is differen, if non-zero gross inernaional asse posiions are considered in he seady sae. The resuling impulse responses for he bonds-only scenario are depiced in Figure (6). Again, he depreciaion increases he home counry s ne foreign asse 3

31 Figure 6: Impulse responses for B=%, LCP oupu: home, foreign consumpion: home, foreign.5 dom. invesmen: home, foreign erms of rade.5.5 profis h and f valeff x ib, ib* 3 5 curren accoun, NFA nom. and real exch. rae.5 real income h and f.5.5 ime.5 ime posiion, and home currency earnings on foreign bonds furher raise he increase in real home income. Thus, he valuaion effec for bonds is no affeced by he price seing behavior of firms FDI only, LCP Figure (7) depics he resuling impulse responses for he assumpion of 5% crosscounry capial ownership in he seady sae. Recall ha for he assumpion of PCP, foreign households were able o paricipae in he boom in demand for home goods induced by a moneary expansion in he home counry, as long as hey own a par of he capial sock used for producion in he home counry. However, for he assumpion of 3

32 Figure 7: Impulse Responses for Foreign Direc Invesmen, LCP oupu: home, foreign consumpion: home, foreign.5 dom. invesmen: home, foreign erms of rade.5.5 profis h and f firms.. FDI home & foreign 4 ime.5 5 x ib, ib* 3 5 curren accoun, NFA 4 valeff o & bond.5.5 ime nom. and real exch. rae.5.5 real income h and f.5.5 valeff equiies & capial.5.5 ime LCP, he expendiure-swiching effec vanishes, and he rise in home demand is direced owards boh home and foreign goods proporionaely. Thus, compared o Figure (3), he risk-sharing propery of FDI is less imporan in such a siuaion. As he redisribuional channel of he exchange rae change remains acive, a welfare enhancing effec for home agens in response o an expansionary moneary shock becomes much more likely Bonds, FDI and Equiies, LCP The corresponding resul also holds, if non-zero gross inernaional invesmen posiions are considered in all hree caegories, as shown in Figure (8). Again, he risk-sharing 3

33 Figure 8: Impulse Responses for posiive inernaional invesmen posiion in Bonds, FDI and Equiies, LCP oupu: home, foreign consumpion: home, foreign.5 dom. invesmen: home, foreign erms of rade.5.5 profis h and f firms.. FDI home & foreign 4 ime.5 5 x ib, ib* 3 5 curren accoun, NFA 6 4 valeff o & bond.5.5 ime nom. and real exch. rae.5 real income h and f.5.5 valeff equiies & capial.5.5 ime propery of FDI is reduced. Noe, ha for he assumpion of flexible wages and sicky prices, he aboliion of he expendiure-swiching effec induces a redisribuion of profi declines. Whereas home profis sill fall (albei by less han compared o Figure (4)), foreign firms profis decline as well, as producion in he foreign economy rises. Thus, compared o he PCP scenario, he endured losses of foreign households due o foreign equiy holdings are smaller. However, he overall effec on real income appears o be small. 33

34 4 Conclusion In his paper, we invesigae he implicaions of increasing inernaional financial inegraion, experienced in mos indusrialized counries during he pas wo decades, on he effecs of moneary policy. I was shown, ha he exisence of large amouns of foreign asses and liabiliies opens up a second ransmission channel for moneary policy in an open economy in addiion o he rade channel. This has several implicaions: Firs, he value of foreign currency denominaed asses and liabiliies will vary proporionaely wih exchange rae changes. Second, asse prices such as equiy prices migh also be affeced direcly by moneary policy, also resuling in corresponding revaluaions of inernaional invesmen posiions. Finally, domesic currency reurns on foreign asses will also vary wih exchange rae changes, bu migh also be affeced direcly by he consequences of he moneary policy shock. The main conribuion of his paper is ha we include hree differen ypes of inernaional financial inegraion rade in bonds, equiies as well as FDI joinly in a wo-counry DSGE model wih sicky prices. Due o he increasing imporance of FDI and equiies, and he underlying higher variance of heir reurns, allowing for non-zero inernaional invesmen posiions in hese wo caegories seems o be an imporan feaure of a model ha aims a undersanding he consequences of financial globalizaion. We find ha in he curren specificaion wihou sicky wages, he manipulaion of he exchange rae is more favorable for a counry, he more is inhabians own foreign bonds and equiies, he less foreign owned capial is used in he home producion process and he more firms are likely o price-discriminae beween he wo markes. This resul is due o he risk-sharing properies of FDI. In response o a moneary expansion in he home counry, demand for home goods increases, which raises reurns on home facor inpus. As a resul, reurns on home capial owned by foreign households rise in foreign currency despie he depreciaion of he home currency, and foreign real income rises. 6 Hence, he ownership of capial employed in he foreign producion process can serve as 6 This is especially he case for he assumpion of producer-currency price-seing behavior of firms. 34

35 an insurance agains asymmeric demand bu also agains supply shocks. On he conrary, non-zero inernaional invesmen posiions in equiies do no feaure his propery in he curren specificaion of he model. Noe, however, ha risk-sharing properies are likely o emerge as soon as we allow for wage rigidiies, which we inend o include in a laer version. Furhermore, o assess he incenive for a counry o manipulae is exchange rae via moneary policy, he resuling welfare implicaions also need o be compued, and a sensiiviy analysis needs o be conduced. 35