Survey_CJ_2009

Abstract

We model the motives for residents of a country to hold foreign assets, including the precautionary motive that has been omitted from much previous literature as intractable. Our model captures many of the principal insights from the existing specialized literature on the precautionary motive, deriving a convenient formula for the economy’s target value of assets. The target is the level of assets that balances impatience, prudence, risk, intertemporal substitution, and the rate of return. We use the model to shed light on two topical questions: The “upstream” flows of capital from developing countries to advanced countries, and the long-run impact of resorbing global financial imbalances. This paper introduces a tractable model that can be used to analyze these questions and others. The model is a small-open-macroeconomy version of the model of individual precautionary saving developed by Carroll (2009a), based on Toche (2005) (see also Sargent and Ljunqvist (2000)). The model permits us to characterize the dynamics of foreign asset accumulation with phase diagrams that should be readily understandable to anyone familiar with the benchmark Ramsey model of economic growth, and to derive closed-form expressions that relate the target level of net foreign assets to fundamental determinants like the degree of risk, the time preference rate, and expected productivity growth. The model’s structure is simple enough to permit straightforward calculations of welfare-equivalent tradeoffs between growth, social insurance generosity, and risk. We consider a small open economy whose population and productivity grow at constant rates. A resident of this economy accumulates precautionary wealth in order to insure against the risk of unemployment, which results in complete and permanent destruction of the individual’s human capital.6,7 The saving decisions of our individuals aggregate to produce “net foreign assets” for the economy as a whole.