should satisfy the following: Equation (29) means that C and O will choose an optimal bond portfolio so that the differential in their marginal utilities on average is not correlated to the return differential of their bond holdings. In other words, their consumption is on average insured against the monetary shocks and real shocks to P and C’s tradable endowments.

Taking a second-order logarithmic approximation of the country C and country O portfolio firstorder conditions and combining them yields: where _x_ ˆ denotes log deviations from the steady state value of the variable. _co_<sup>_i_</sup> _j_<sup>arethecoefficientson</sup> _<u>c</u>_<sup>_i_</sup> variable _j_ of country _i_ and they are as follows: _co_<sup>_i_</sup> _ct_<sup>=</sup><sup>_γ−_1</sup><sup>_−σγ_</sup> _ci−_ Φ<sup>_<u>li</u>_</sup> 1+<sup>1+</sup> _ν_<sup>_ν_</sup> , _co_<sup>_i_</sup> _cn_<sup>=1</sup><sup>_−γ−σ_(1</sup><sup>_−_</sup> _<u>c</u>_<sup>_i_</sup> _<u>l</u>_<sup>_i_1+</sup><sup>_ν_</sup> _γ_ ) _c_<sup>_i_</sup> _−_ Φ<sup>_<u>li</u>_</sup> 1+<sup>1+</sup> _ν_<sup>_ν_</sup> , _co_<sup>_i_</sup> _l_<sup>=</sup><sup>_σ_Φ</sup> _c_<sup>_i_</sup> _−_ Φ<sup>_<u>li</u>_</sup> 1+<sup>1+</sup> _ν_<sup>_ν_</sup> .

The details of the solution method are presented in Appendix A.

# _4.2. Baseline Calibration and the Steady State_

The value of the discount factor is set for quarterly data: _β_ = 0 _._ 98. The share of tradable consumption is a third of total consumption: _γ_ =<sup><u>1</u></sup> 3<sup>.FollowingChugh(2006),weset</sup><sup>_χ_equal0</sup><sup>_._05,</sup> the elasticities of substitution _ωF_ = 10. We set the endogenous discount factor coefficient very small _μ_ = 0 _._ 001, so that it does not have a significant impact on the model’s dynamics. We also set the persistence of money supply to 0.9, and the persistence of endowment to 0.8. We set _κ_ equal to 0.75, implying that the average period between price adjustments is four quarters, as in Bernanke et al. (1999). The correlations of P, C and O’s endowments are consistent with the data.<sup>11</sup> The steady state of the three-economy system is summarized in Table 2 and they seem quite reasonable. Overall, the share of the non-tradable good value is about two-thirds of total consumption in all the economies. Country P’s net foreign asset position is negative (which means P is borrowing) and about -100 % of its total output, whereas the size of countries O and C’s NFA position ranges from about 40% to 60% of their total output. The next section will discuss the steady state values of the bond portfolio holdings.

# **5. Results**

In this section we introduce the results of the model. First, we present the steady state portfolio holdings. Using three exercises, we demonstrate the importance of the business cycle and the currency risk channels by studying the changes in the steady state portfolio holdings in response to the changes

> 11Peripheral EMU consists of Italy, Spain, Portugal, Greece. Core EMU consists of France, Germany, Belgium. Outsider economies consist of United States, United Kingdom, Switzerland and Japan. Data is obtained from the OECD. For each group, we divide the total quarterly real GDP by the total population to obtain the group quarterly real GDP per capita. The moments are calculated from the series of the groups’ quarterly real GDP growth.

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