Abstract

This paper analyzes the behavior of international gross capital flows over the business cycle in a two-country DSGE portfolio choice model with shocks to both the transitory and trend components of the endowment. Empirical work on international capital flows documents weakly procyclical, and at times, countercyclical gross financial flows between economies. This observation cannot be reconciled with the predictions of the standard open economy model. These models typically employ transitory productivity shocks as the main driver of business cycles. However the recent theoretical and empirical literatures emphasize the importance of shocks to the trend component of output in matching business cycle moments with data. Our main finding is that transitory shocks result in strongly procyclical gross capital flows, while trend shocks yield weakly countercyclical gross outflows and weakly procyclical gross inflows. Overall, both the magnitude and the sign of correlation coefficients from our model are more consistent with the empirical evidence in the literature. We demonstrate that transitory shocks alone cannot produce results that are in line with the empirical evidence. This finding holds true for different levels of persistence of the transitory shocks. We illustrate that empirically sound predictions are the result of the separation of the transitory and trend shocks.

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