International macro-finance

Anna Pavlova, Roberto Rigobon

15 February 2011



Financial markets and their role in international risk sharing have inspired a vast body of theoretical literature. Over the past 40 years, international finance and economics has evolved into a vibrant field spreading from the basic international version of the capital asset pricing model to some of the most sophisticated dynamic stochastic general equilibrium models.

Curiously, however, the research effort in economics has evolved almost in parallel with that in finance. In economics, the main focus has been on real quantities and international relative prices such as consumption, investment, current account, terms of trade and exchange rates. Meanwhile, international portfolio choice and international equity markets have been largely overlooked. Indeed, the asset structure of these models has been mostly of two types: either the only asset is an international bond and markets are incomplete, or there is a full set of Arrow-Debreu securities and markets are complete.

Both approaches have been very useful, but they cannot address many questions pertaining to portfolio problems and to the international equity markets. Finance, on the other hand, has focused more on cross-country portfolio allocations and asset prices. Terms of trade and hence exchange rates have been largely overlooked because the majority of the models featured a single-good framework, in which forces of arbitrage equate terms of trade to unity. Models with endogenous portfolio selection, equity prices and time-varying terms of trade and exchange rates in a single framework have been quite rare.

Although we have learned a tremendous amount from this research, in recent years two main phenomena have required a redefinition of the agenda behind the theories of financial markets in the international context:

  • Contagion among developed and relatively unconnected countries.

Contagion refers to the transmission of crises from one country to another. Prominent examples of this phenomenon include the 1997 Asian crisis, the 1998 Russian crisis, and the subprime mortgage crisis of 2007-2008. Policymakers are now worried about contagion that could be sparked by possible Greek default. It is difficult to address this phenomenon within standard macro models. Indeed, the turmoil is thought to be transmitted, most likely, through the financial sector, which is missing from these models.

  • The role that asset prices and exchange rates play in the global imbalances (Editor’s note, see the recent CEPR Policy Insight from Leijonhufvud 2011).

The second significant development that has influenced the literature has been the unprecedented rise in external deficits in many developed nations, which has sparked a discussion about sustainability and the possible dramatic unravelling of global imbalances (with Nouriel Roubini making particularly striking predictions).

The rise in external deficits, however, came hand-in-hand with the explosion in cross-border risky asset holdings. Before 1985, the US held virtually no foreign equities; nowadays, foreign equities account for a large and growing part of the country's assets. Following influential work of Lane and Milesi-Ferretti (2001) and Gourinchas and Rey (2007), it has become clear that (unrealised) capital gains on these equity positions are missing from national accounts. The alarming current-account deficits worldwide may then be simply due to this misreported income from equity positions. Today an extremely active literature, both empirical and theoretical, is trying to better understand how the capital gains on foreign equity positions, or the so-called valuation effects, affect our thinking about the current account and the external adjustment process.

Unfortunately, most of the existing international macro models are not well-suited for dealing with these issues because they are missing equity markets and portfolio choice. A new and rapidly growing strand of literature, commonly known as international macro-finance, is trying to fill this gap. This new generation of macro models provides a redefinition of the current account (adjusted for capital gains on equity holdings) and modifies the standard theories of the current account. More generally, this research programme focuses on the interaction between the financial sector and the real economy, and as such can address a wide spectrum of issues such as contagion, composition of international portfolios, valuation effects, and others.

The modelling framework

The framework that has become the core of international macro-finance consists primarily of general equilibrium asset-pricing models with multiple goods. The richness of this framework comes at a cost: most of the macro-finance models are quite complex. Problems involving portfolio choice are particularly difficult to analyse because for these problems standard first-order approximation methods cannot deliver desired results. Engel and Matsumoto (2006), Devereux and Sutherland (2010), and Tille and van Wincoop (2010) have developed an approach based on higher-order approximations around a deterministic steady state. It is a powerful technique. However, its disadvantage is that to this day little is known about the behaviour of these economies away from the deterministic steady state, where the underlying volatilities are not small.

Another strand of the macro-finance literature simplifies the models and seeks to find exact solutions. The main advantage of this approach is that the economy can be analysed away from the steady state, but the disadvantage is that solutions only exist in few special cases. An early work that presents one of such special cases is Helpman and Razin (1978). Their setup has been developed further by a number of authors, including Cole and Obstfeld (1991) and Pavlova and Rigobon (2007). These papers consider pure-exchange economies in which a representative agent in each country has log-linear preferences. In recent years the literature has made progress extending the setup beyond log-linear preferences. The solution is especially simple in complete markets, but the models remain tractable even in the presence of market frictions (see Pavlova and Rigobon 2011 for an elabouration and references).

In January 2010, the Journal of International Economics ran a special issue on international macro-finance. This collection of works gives an excellent overview of the latest contributions to this field and provides further references.

Next steps: Areas for further research

Although we have learned a great deal from this strand of research, many questions remain open. In order to tackle more ambitious questions raised by the data and current events, the existing models certainly require improvements along several dimensions.

  • First, the discussion of global imbalances, current account sustainability, and, more generally, of international portfolios and risk sharing requires the introduction of market incompleteness into the story. This direction is important not only because markets are generally believed to be incomplete, but also because there is no role for policy under complete markets (an allocation is already Pareto efficient). Having incomplete markets adds a layer of methodological complexity (we provide details in Pavlova and Rigobon 2010). In his Ohlin lecture, Maurice Obstfeld remarks that “portfolio choice under incomplete markets is largely terra incognita.” Developing such models and understanding their workings constitutes frontier research in international macroeconomics these days.
  • Second, many models that have been developed in international macro-finance so far feature pure-exchange economies. This view of production is too simplistic. The natural next step is to include factors of production into these asset pricing models. Labour market considerations such as effort and unemployment, as well as investment, are important elements through which the real economy and financial markets interact with each other.
  • Third, our models are missing a full-fledged financial sector, the importance of which has been underscored by a series of recent contagious crises. The first step could be to model the financial inefficiencies stemming from the organisational structure of the financial sector in reduced-form – for example, in the form of financial constraints on certain market participants (e.g., margin constraints), which may prevent them from supplying liquidity at times when it is needed the most. The next step would then be to introduce agency problems and endogenise these constraints. The fact that constraints on traders that we observe in the real world tend to bind at the same time, normally in bad times, can emerge as one of the leading explanations of contagion and as a channel of propagation of systemic risk.
  • Finally, as our models get progressively more complicated, we will need to rely on numerical methods. The literature is now testing the appropriateness of higher order approximation methods, with the approximations taken around a deterministic steady state. Perhaps even more complex methods (finite-element methods or projection methods) are required.

The field of international macro-finance is a new and active area of research. There are many ways in which one can push its frontier. Here we have highlighted just several possible promising directions. We are sure that there are many more.


Cole, HL and M Obstfeld (1991), “Commodity Trade and International Risk Sharing”, Journal of Monetary Economics, 28:3-24.
Devereux, MB and A Sutherland (2010), “Country Portfolios in Open Economy Macro Models”, Journal of the European Economic Association, forthcoming.
Engel, C and A Matsumoto (2006), “Portfolio Choice in a Monetary Open-Economy DSGE Model”, working paper, University of Wisconsin.
Gourinchas, P-O and H Rey (2007), “International Financial Adjustment”, Journal of Political Economy, 115:665-703.
Helpman, E and A Razin (1978), A Theory of International Trade under Uncertainty. Academic Press, San Diego.
Lane, PR and GM Milesi-Ferretti (2001), “The External Wealth of Nations: Measures of Foreign Assets and Liabilities for Industrial and Developing Countries”, Journal of International Economics, 55:263-294.
Leijonhufvud, Axel (2011), “Nature of an economy”, CEPR Policy Insight No. 53.
Pavlova, A and R Rigobon (2007), “Asset Prices and Exchange Rates”, Review of Financial Studies, 20:1139-1181.
Pavlova, A and R Rigobon (2010), “Equilibrium Portfolios and External Adjustment under Incomplete Markets”, mimeo, MIT.
Pavlova, A and R Rigobon (2011), “International Macro-Finance”, mimeo, MIT.
Tille, C and E van Wincoop (2010), “International Capital Flows”, Journal of International Economics, 80:157-175.



Topics:  Frontiers of economic research International finance

Tags:  financial regulation, macroeconomic policy, international macro finance

Associate Professor of Finance at London Business School, CEPR Research Affiliate

Society of Sloan Fellows Professor of Applied Economics at the Sloan School of Management, MIT