The international diversification puzzle is the fact that country portfolios are on average biased toward domestic assets, while one-good international macro models with nondiversifiable labor income risk predict the opposite pattern of diversification. This paper embeds a portfolio choice decision in a two-good international business cycle model and provides a closed-form solution for equilibrium country portfolios. Equilibrium portfolios are biased toward domestic assets because endogenous international relative price fluctuations make domestic assets a good hedge against labor income risk. Evidence from developed economies in recent years is qualitatively and quantitatively consistent with the mechanisms highlighted by the theory.
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