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A theory of capital flow retrenchment

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  • Davis, J. Scott
  • van Wincoop, Eric

Abstract

During a downturn in the global financial cycle there is a simultaneous retrenchment in gross capital flows and a fall in risky asset prices. The global financial cycle is closely related to fluctuations in risk appetite. We develop a model that can simultaneously produce a fall in gross outflows, inflows, and asset prices following an increase in global risk aversion. There is heterogeneity across investors within a country in the willingness to hold risky assets and to hold foreign assets. The fall in the asset price after a rise in global risk aversion shifts the wealth distribution towards investors that are less willing to hold foreign assets. This leads a drop in gross flows. We calibrate the within country heterogeneity in the model to match heterogeneity observed in micro data of household portfolios. The retrenchment in the calibrated model is quantitatively similar to what we observe in the macro data.

Suggested Citation

  • Davis, J. Scott & van Wincoop, Eric, 2024. "A theory of capital flow retrenchment," Journal of International Economics, Elsevier, vol. 150(C).
    • Handle: RePEc:eee:inecon:v:150:y:2024:i:c:s0022199624000795
    DOI: 10.1016/j.jinteco.2024.103952
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    Cited by:

    1. Guillermo Hausmann-Guil, 2025. "Solving DSGE models with incomplete markets by perturbation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 57, July.
    2. Davis, J. Scott & van Wincoop, Eric, 2025. "A theory of net capital flows over the global financial cycle," Journal of Monetary Economics, Elsevier, vol. 149(C).

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    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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