Trade Costs, Asset Market Frictions and International Macro Puzzles

Stanford University, Stanford CA

Investigators

Abstract

There is abundant evidence that there are frictions in international asset markets. Each decade, some countries default on their debts, and periodically these episodes combine into full-blown international financial crises. Empirical work over the past 10 years has also demonstrated that costs of trading goods are large and important for explaining the pattern of bilateral trade. The goal of this project is to disentangle empirically the contribution of goods and asset-market frictions in explaining a set of puzzles in international macroeconomics. The first step of the project develops a multi-country model where it is costly to ship goods across countries, and there may be limitations on the types of inter-temporal contracts that countries can write with each other. In this world, countries optimally choose not to smooth their consumption perfectly across goods, states of the world and over time, even if there are no restrictions on the inter-temporal contracts they can write. The second step of the project uses the model to develop and implement a new test for international consumption risk sharing using a sample of 80 countries. Preliminary results suggest that both costly trade and frictions in asset markets are necessary to explain the failure of perfect consumption insurance across countries. The third step of the project investigates the nature of the salient limitations on the inter-temporal contracts countries can write with each other. The absence of an authority that enforces contracts between parties from different countries may reduce the set of feasible contracts to those that are self-enforcing. Many of the instruments used in international financial transactions do not make payments contingent on the circumstances in which the parties find themselves ex post. Different limitations on contracts have different implications for the evolution of the cross-country distribution of wealth. The model developed in the first stage of the project provides a method for estimating the international wealth distribution, and hence testing these implications. The propensity of agents to hold portfolios that are strongly tilted towards domestic assets has been called a puzzle. Given the results from the analysis of the most appropriate way of modeling frictions in international asset markets, the fourth step of the project will explore the degree to which country portfolios are consistent with the evidence on the nature and size of trade costs and frictions in asset markets. The final step of the project addresses the contribution of trade costs and asset market frictions to the exchange-rate disconnect puzzle. The results of this project contribute to our understanding of the quantitative importance of goods versus financial market frictions in impeding international market integration. Given the goods market frictions and asset market structure preferred by the data, it is possible to analyze the welfare benefits of policies designed to ameliorate these frictions. This helps in the design of government policy that has the aim of further integrating markets internationally, thereby giving this research broader impacts.