This paper explores the valuation channel of external adjustment in a two-country dynamic
stochastic general equilibrium model (DSGE) with international equity trading. The theoretical model we set up matches key moments of
the data for the United States at business cycle frequency at least as well as standard models
of international real business cycles (RBCs). In our theoretical analysis, we find that two-asset
trading is necessary for a valuation channel of external adjustment to emerge. However, other
features of the economy, such as on the nature of the shock that generates the external imbalance
and other features of the economy â€“ the extent of nominal rigidity and the size of finacial frictions â€“ determine the magnitude and significance of this channel of adjustment. The relative importance of the valuation channel is larger the higher the degree of nominal rigidity and the higher finacial intermediation costs. Monetary policy shocks have no valuation effects with flexible prices and trade only in equity. Specifying the theoretical model with net foreign assets different from zero in necessary to start matching satisfactorily empirical moments of changes in the US net foreign asset position.
Ongoing international financial integration has greatly increased foreign asset holdings across countries, enhancing the scope for a "valuation channel" of external adjustment (i.e., the changes in a country's net foreign asset position due to exchange rate and asset price changes). We examine this channel of adjustment in a dynamic stochastic general equilibrium model with international equity trading in incomplete asset markets. We show that the risk-sharing properties of international equity trading are tied to the distribution of income between labor income and profits when equities are defined as claims to firm profits in a production economy. For a given level of international financial integration (measured by the size of gross foreign asset positions), the quantitative importance of the valuation channel of external adjustment depends on features of the international transmission mechanism such as the size of financial frictions, substitutability across goods, and the persistence of shocks. Finally, moving from less to more international financial integration, risk sharing through asset markets increases, and valuation changes are larger, but their relative importance in net foreign asset dynamics is smaller.
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