Nº 21-80: Can Sticky Portfolios Explain International Capital Flows and Asset Prices?

Recently portfolio choice has become an important element of many DSGE open economy models. Yet, a substantial body of evidence is inconsistent with standard frictionless portfolio choice models. In this paper we introduce a quadratic cost of changes in portfolio allocation into a two-country DSGE model. We investigate the level of portfolio frictions most consistent with the data and the impact of portfolio frictions on asset prices and net capital flows. We find the portfolio friction accounts for (i) micro evidence of portfolio inertia by households, (ii) macro evidence of the price impact of financial shocks and related disconnect of asset prices from fundamentals, (iii) a broad set of moments related to the time series behavior of saving, investment and net capital flows, and (iv) other phenomena relating to excess return dynamics. Financial and saving shocks each account for close to half of the variance of net capital flows.