Working Paper: CEPR ID: DP13819
Authors: Ricardo Caballero; Alp Simsek
Abstract: We develop a model of gross capital flows and analyze their role in global financial stability. In our model, consistent with the data, when a country experiences asset fire sales, foreign investments exit (fickleness) while domestic investments abroad return home (retrenchment). When countries have symmetric expected returns and financial development, the benefits of retrenchment dominate the costs of fickleness and gross flows increase fire-sale prices. Fickleness, however, creates a coordination problem since it encourages local policymakers to restrict capital inflows. When countries are asymmetric, capital flows are driven by additional mechanisms, reach-for-safety and reach-for-yield, that can destabilize the receiving country.
Keywords: gross capital flows; global liquidity; fickleness; retrenchment; asset fire sales; capital controls; policy coordination; scarcity of safe assets; reach-for-safety; reach-for-yield
JEL Codes: E3; E4; F3; F4; F6; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Liquidity shock (E44) | Foreign investments exit (F21) |
| Liquidity shock (E44) | Domestic investments return home (F21) |
| Fickleness (E32) | Capital inflows restricted (F21) |
| Retrenchment dominates costs of fickleness (D21) | Increased gross capital flows (F32) |
| Retrenchment increases domestic liquidity during distress (E44) | Mitigating financial instability from fickleness (E44) |
| Regulating capital flows (F32) | Coordination problem (P11) |
| Capital flows (F32) | Resale prices increase (R31) |
| Coordination of capital flows (F32) | Enhances global liquidity (F30) |
| Local and foreign investments (F21) | Endogenous price of assets (G19) |