The composition effect of the current account in small open economies

Abstract

A common problem in international finance consists of the indeterminacy of the equilibrium asset portfolio in small open economy models. This paper develops a simple approach to compute this portfolio under the assumption of incomplete nancial markets. The procedure involves the limiting allocation of a class of two-country world economies where the relative size of one of them tends to zero. Such approach allows to identify the e ect of portfolio decisions on the dynamics of the net foreign asset position of a small open economy in a structural fashion. As an illustration, an approximated closed-form solution is obtained for a highly stylized model that is isomorphic to the class of Dynamic Stochastic General Equilibrium (DSGE) models typically used in the literature.