Nominal exchange rates and net foreign assets' dynamics: The stabilization role of valuation effects

This paper proposes a parsimonious OLG model with output shocks to shed light on the impact of the nominal exchange rate on the dynamics of net foreign assets through valuation effects. We show that an increase in the share of world GDP leads to a trade surplus and negative valuation effects through an appreciation of the nominal exchange rate. The lack of perfect arbitrage in the model implies that the valuation channel is a key component of the process of external adjustment, consistently with the empirical literature. Finally, we provide empirical evidence in support of the role of the share of world GDP in generating trade balance and exchange rate/valuation effects dynamics.