Valuation effects with transitory and trend productivity shocks

Changes in asset prices of a country's foreign assets and liabilities ("valuation effects") are commonly thought of as stabilizing: they counteract current account movements and mitigate the impact of the current account on the country's net foreign asset (NFA) position. This paper shows that whether valuation effects are stabilizing or not depends critically on the nature of the underlying productivity shocks. In response to transitory shocks, valuation effects are stabilizing; but in response to trend shocks, such effects amplify the impact of the current account on NFA position. These contrasting effects arise because optimally smoothing consumers respond differently to a transitory shock than to a trend shock to income. This theoretical result finds empirical support with G7 countries' data, and is illustrated by the pattern of external imbalances between the U.S. and other G7 countries since the 1990s. (C) 2011 Elsevier B.V. All rights reserved.