The Risk Premium and Long-Run Global Imbalances

50 Pages Posted: 28 Oct 2011 Last revised: 8 Feb 2012

See all articles by YiLi Chien

YiLi Chien

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Kanda Naknoi

Purdue University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: October 28, 2011

Abstract

Our paper investigates whether the valuation effect caused by a large risk premium and a low risk-free rate can help to explain the enormous US current account and trade deficit observed in the past decade. To answer this question, we set up an endowment growth model in which investors are endowed with heterogeneous trading technologies. In our model, the average US investors load up more aggregate risk by investing in a risky asset abroad and issuing a risk-free asset. Thanks to the large risk premium as well as the low risk-free rate, the US can sustain a long-run trade deficit even as a debtor country. Quantitatively, we find that the valuation effect caused solely by the high risk premium and the low risk-free rate in our model, which is calibrated to match the external assets and liabilities of the US economy, can account for more than half of the observed trade deficit and current account deficit. Our results suggest that the current US trade deficit might not necessarily lead to net export increases or dollar depreciation in the future.

Keywords: Global Imbalances, External Account, Risk Premium, Asset Pricing, Limited Participation

JEL Classification: E21, F32, F41, G12

Suggested Citation

Chien, YiLi and Naknoi, Kanda, The Risk Premium and Long-Run Global Imbalances (October 28, 2011). Available at SSRN: https://ssrn.com/abstract=1950731 or http://dx.doi.org/10.2139/ssrn.1950731

YiLi Chien (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Kanda Naknoi

Purdue University - Department of Economics ( email )

West Lafayette, IN 47907-1310
United States

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