DP13819 A Model of Fickle Capital Flows and Retrenchment

Author(s): Ricardo Caballero, Alp Simsek
Publication Date: June 2019
Keyword(s): asset fire sales, capital controls, fickleness, Global liquidity, Gross capital flows, Policy Coordination, reach-for-safety, reach-for-yield, retrenchment, scarcity of safe assets
JEL(s): E3, E4, F3, F4, F6, G1
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13819

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, which can destabilize the receiving country.