DP6705 International Capital Flows

Author(s): Cédric Tille, Eric van Wincoop
Publication Date: February 2008
Keyword(s): home bias, international capital flows, portfolio allocation
JEL(s): F32, F36, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6705

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