International capital flows

Most existing theories of international capital flows work in settings with a single risk-free bond, which can speak only to net capital flows – there is no portfolio choice, hence no role for gross flows driven by differences in expected returns or in the riskiness of assets. This paper develops a general method for solving dynamic stochastic general-equilibrium (DSGE) open-economy models in which households actively choose a portfolio across multiple assets, and shows why the standard perturbation techniques used to solve DSGE models order by order break down once portfolio choice is present: the zero-order (steady-state) difference between Home and Foreign investors’ portfolio shares can only be pinned down using the second-order component of the portfolio optimality conditions, and its first-order (time-varying) component requires going all the way to the third-order component of those conditions – terms that are ordinarily treated as negligible. The paper shows how to solve this fixed-point problem systematically, and that computing gross capital flows and gross external positions (unlike net flows, which need only the model’s ordinary first-order solution) requires this harder, higher-order step. Applying the method to a symmetric two-country, two-good, two-asset (Home and Foreign equity) model with a small, second-order iceberg-style cost of investing abroad, the authors decompose steady-state home bias in equity holdings into three forces – the cost of foreign investing itself, the covariance between the real exchange rate and the domestic excess return, and a hedging motive against future changes in expected portfolio returns – and show numerically, for a persistent Home productivity shock, that the resulting gross capital flows are driven mainly by active portfolio reallocation rather than by the mechanical growth of existing portfolios with national saving, and that changes in expected excess returns are frequently unrelated to capital flows at all. The method also permits welfare analysis: in the paper’s calibration, a financial friction of 0.4% is estimated to cost a representative investor a welfare loss equivalent to about 1.2% of wealth.

Eric Van Wincoop | Macro Paper Warehouse

International capital flows