Portfolio Diversification, Real Interest Rates, and the Balance of Payments

Abstract

The paper shows that differences in real interest rates across countries can arise even with perfect competition and fully integrated international capital markets. Specifically, we find that factor returns will differ across countries which are identical except for differences in technological riskiness, overall productivity, or labor force size. We also show that differences across countries in technological riskiness, in risk aversion, in population size and in overall productivity will lead to a non-zero current account in the steady state. Higher technological riskiness, greater risk aversion, and a larger population should be associated with a current account surplus. The analysis is carried out using a two-country Diamond overlapping-generations model in which technological uncertainty is reflected in factor returns.