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Authors:

• Eric Van WINCOOP
  University of Virginia and NBER

• Cedric TILLE

The sharp increase in both gross and net capital flows over the past two decades has lead to a renewed interest in their determinants. Most existing theories of international capital flows are in the context of models with only one asset, implying that two-way flows are impossible and there is no role for portfolio choice. In this paper we develop a method for solving stochastic general equilibrium open-economy models of portfolio choice. We show why standard first- and second-order methods to solve stochastic general equilibrium models no longer work in the presence of portfolio choice. We then extend the standard solution method in a way that gives special treatment to the optimality conditions for portfolio choice. We apply the solution method to a particular two-country, two-good, two-asset model and show that it leads to a much richer understanding of both gross and net capital flows. The approach highlights time-varying portfolio shares as a potential key source of international capital flows. The model also illustrates the role of expected and unexpected valuation effects in the external adjustment process, which have received significant attention in recent years.