Working Paper: NBER ID: w12856
Authors: Eric Van Wincoop; Cedric Tille
Abstract: The sharp increase in both gross and net capital flows over the past two decades has led to a renewed interest in their determinants. Most existing theories of international capital flows are in the context of models with only one asset, which only have implications for net capital flows, not gross flows. Moreover, there is no role for capital flows as a result of changing expected returns and risk-characteristics of assets as there is no portfolio choice. In this paper we develop a method for solving dynamic stochastic general equilibrium open-economy models with portfolio choice. We show why standard first and second-order solution methods no longer work in the presence of portfolio choice, and extend them giving special treatment to the optimality conditions for portfolio choice. We apply the solution method to a particular two-country, two-good, two-asset model and show that it leads to a much richer understanding of both gross and net capital flows. The approach highlights time-varying portfolio shares, resulting from time-varying expected returns and risk characteristics of the assets, as a potential key source of international capital flows.
Keywords: international capital flows; portfolio choice; dynamic stochastic general equilibrium
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 |
|---|---|
| time-varying expected returns (G17) | international capital flows (F32) |
| risk characteristics (G22) | international capital flows (F32) |
| capital flows (F32) | savings growth (E21) |
| capital flows (F32) | optimal reallocation of portfolios (G11) |
| expected excess returns (G17) | portfolio shares (G11) |
| variances of expected excess returns (C29) | portfolio shares (G11) |
| portfolio shares (G11) | international capital flows (F32) |
| valuation effects (Q51) | international capital flows (F32) |