Time-Varying Preferences and International Capital Markets

This project was part of the team project "Social Finance – Finance and the Consumer".

Topic & Objectives

The traditional international finance literature assumes that preferences for traded goods are constant over time. ln this project we assume that investors' preferences are time-varying because they depend on the local popularity (in terms of sales) of internationally traded goods. 

We design a model with two countries, for brevity named home and foreign country. In each country, agents make consumption choices based on the local popularity of traded goods. Also, people are more sensitive to the popularity of the home good than to the popularity of the foreign good. For instance, the home agent Iooks at the popularity of the home good in the home country: If the popularity of the home good is high, the home agent increases her preference for the home good, decreases her preference for the foreign good and modifies her consumption basket accordingly. The agent will then select her optimal portfolio to finance the desired consumption plan. 

This mechanism helps explain several puzzles in the international finance Iiterature such as a Iack of risk sharing, a Iack of portfolio diversification and, more generally, fluctuations in asset prices and exchange rates.

We test our model empirically using data from the United States, the United Kingdom and Germany.