Working Paper

A Theory of Capital Flow Retrenchment

Abstract: The empirical literature shows that gross capital inflows and outflows both decline following a negative global shock. However, to generate a positive co-movement between gross inflows and outflows, the theoretical literature relies on asymmetric shocks across countries. We present a model where there is heterogeneity across investors within countries, but there are no asymmetries across countries. We show that a negative global shock (rise in global risk-aversion) generates an identical drop in gross inflows and outflows. The within-country heterogeneity relates to the willingness of investors to hold risky assets and foreign assets.

Keywords: capital flows; retrenchment; Portfolio Heterogeneity;

JEL Classification: F30; F40;

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Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2023-08-24

Number: 422

Note: This paper is related to a previous draft titled “A Theory of Gross and Net Capital Flows over the Global Financial Cycle.” This paper focuses on gross capital flows, while a separate paper considers net capital flows.

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