Portfolio Choice in a Monetary Open-Economy DSGE Model

IMF Working Papers, August 1, 2005

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This paper develops a two-country monetary DSGE (dynamic stochastic general equilibrium) model in which households choose a portfolio of home and foreign equities, and a forward position in foreign exchange.
Some goods prices are set without full information of the state.
Home and foreign portfolios are not identical in equilibrium.
In response to technology shocks, sticky prices generate a negative correlation between labor income and the profits of domestic firms, biasing portfolios in favor of home equities.
Under flexible prices, labor income and the profits of the domestic firms are positively correlated.

Two-country monetary DSGE framework.
Household portfolio choices include:
- Home equities.
- Foreign equities.
- A forward position in foreign exchange.
Price setting:
- Some goods prices are set without full information of the state (sticky-price environment).
- Comparison with a flexible-price environment is central to the analysis.

Portfolio composition:
- Home and foreign portfolios are not identical in equilibrium.
Effect of technology shocks:
- With sticky prices: negative correlation between labor income and domestic firm profits → portfolios biased toward home equities.
- With flexible prices: positive correlation between labor income and domestic firm profits.
Implication: nominal rigidities (sticky prices) alter the covariance structure between labor income and equity profits, affecting optimal portfolio allocation across home and foreign assets.

IMF Working Paper — Portfolio Choice in a Monetary Open-Economy DSGE Model (Akito Matsumoto; Charles Engel), August 1, 2005.