The Specification and Influence of Asset Markets

Abstract

This paper is a chapter in the forthcoming Handbook of International Economics. It surveys the literature on the specification of models of asset markets and the implications of differences in specification for the macroeconomic adjustment process. Builders of portfolio balance models have generally employed tpostulated asset demand functions, rather than deriving these directly from micro foundations. The first major section of the paper lays out a postulated general specification of asset markets and summarizes the fundamental short-run results of portfolio balance models using a very basic specification of asset markets. Then, rudimentary specifications of a balance of payments equation and goods market equilibrium conditions are supplied, so that the dynamic distribution effects of the trade account under static and rational expectations with both fixed goods prices and flexible goods prices can be analyzed.The second major section of the paper surveys and analyzes micro foundation models of asset demands using stochastic calculus. The microeconomic theory of asset demands implies some but not all of the properties of the basic specification of postulated asset demands at the macro level. Since the conclusions of macroeconomic analysis depend crucially on the form of asset demand functions, it is important to continue to explore the implications of micro foundations for macro specification.

Can trade costs in goods explain home bias in assets?

“…For our purposes, ROW will be composed of an equity-market-capitalization-weighted combination of twenty-one industrialized countries that have complete data. 11 The calculation of the home bias expressions require data for U.S. in ‡ation, U.S. equity returns, as well as three ROW market-capitalization-weighted indexes: a nominal dollar index, an index of foreign equity returns, and a foreign in ‡ation index. In ‡ation (both U.S. and foreign) and equity returns are expressed in dollars.…”

Currency Substitution and Money Demand in Euroland

“…First, as noted by Branson and Henderson [1985], gross substitutability between all assets is not always consistent with individual optimisation. Second, this approach is not capable of explaining why money is held when dominated by interest-bearing assets.…”

“…In the CS literature, two main approaches have been followed: The Portfolio Balance Model (PBM) [Cuddington, 1983;Branson and Henderson, 1985] and the Liquidity Services Model (LSM) [Miles, 1978;Thomas, 1985, Lebre de Freitas andVeiga, 2006]. The PBM follows the aggregative tradition of postulating money demand functions that depend positively on a scale variable, such as income or wealth, and negatively on the return of each alternative asset.…”

On the Contingency of Equilibrium Exchange Rates with Time Consistent Economic Policies

“…Empirical tests then reject the hypothesis of perfect substitutability between short-term domestic and foreign assets (Danker and et al (1987); ). A possible explanation is risk aversion (Branson and Henderson (1985); Bleuze and Sterdyniak (1988)). …”