The International Diversification Puzzle When Goods Prices Are Sticky : It ’ s Really about Exchange - Rate

I n an open macroeconomy, in which asset trade is possible, the portfolio choice of households may play an important role in understanding macro fluctuations. In contrast to a closed economy model, in which a representative agent simply holds the market portfolio, agents in each country may hold different portfolios depending on the country-specific risks and returns that they encounter. Robert E. Lucas, Jr. (1982) provides a fully optimizing model of portfolio balance in which households trade bonds, equities, and claims to monetary transfer from the government. Lucas (1982) and subsequent fully worked-out portfolio balance models have assumed complete nominal goods price flexibility. However, models with sticky nominal goods prices might be appropriate for the consideration of the real consequences of nominal exchange rate fluctuations. Indeed, as we show, the equilibrium portfolio may depend, in important ways, on short-run goods pricing behavior. anonymous referees, and seminar participants at several institutions for helpful comments. Engel acknowledges support from the National Science Foundation through grant SES-0451671 to the University of Wisconsin. The views expressed in this paper are those of the authors and do not necessarily represent those of the Federal Reserve System, the International Monetary Fund (IMF), or IMF policy. Earlier drafts of this paper were circulated under the title " Home Bias in Equities under New Open Economy Macroeconomics, " " Portfolio Choice and Home Bias in Equities in a Monetary Open-Economy DSGE Model, " and " Portfolio Choice and International Risk Sharing in a Monetary Open-Economy DSGE Model. " † To comment on this article in the online discussion forum, or view additional materials, visit the articles page This paper develops a two-country monetary DSGE model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange. Some nominal goods prices are sticky. Trade in these assets achieves the same allocations as trade in a complete set of nominal state-contingent claims in our linearized model. When there is a high degree of price stickiness, we show that not much equity diversification is required to replicate the complete-markets equilibrium when agents are able to hedge foreign exchange risk sufficiently. Moreover, temporarily sticky nominal goods prices can have large effects on equity portfolios even when dividend processes are very persistent.