Working Paper: CEPR ID: DP6705
Authors: Cedric Tille; Eric van Wincoop
Abstract: The surge in international asset trade since the early 1990s has lead to renewed interest in models with international portfolio choice, an aspect that was largely cast aside when the ad-hoc portfolio balance models of the 1970s were replaced by models of optimizing agents. We develop the implications of portfolio choice for both gross and net international capital flows in the context of a simple two-country dynamic stochastic general equilibrium (DSGE) model. Our focus is on the time-variation in portfolio allocation following shocks, and the resulting capital flows. We show how endogenous time-variation in expected returns and risk, which are the key determinants of portfolio choice, affect capital flows in often subtle ways. The model is shown to be consistent with a broad range of empirical evidence. An additional contribution of the paper is to overcome the technical difficulty of solving DSGE models with portfolio choice by developing a broadly applicable solution method
Keywords: home bias; international capital flows; portfolio allocation
JEL Codes: F32; F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| endogenous time variation in expected returns and risk (C22) | capital flows (F32) |
| changes in expected returns (G17) | shifts in portfolio allocations (G11) |
| shifts in portfolio allocations (G11) | capital flows (F32) |
| expected asset price changes (G19) | financing external debt (F34) |
| time-varying second moments (C22) | capital flows (F32) |
| expected return differences (G19) | portfolio choice (G11) |