A Model of Fickle Capital Flows and Retrenchment

Abstract

Gross capital flows are a central aspect of global liquidity creation and destruction. They also exhibit rich internal dynamics that shape fluctuations in domestic liquidity and policy debates, such as the fickleness of foreign capital inflows and the retrenchment of domestic capital outflows during crises. In this paper we provide a global equilibrium model to address some of the main questions and concerns in the capital flows literature. Within this model, we find that for symmetric economies, the liquidity provision aspect of gross capital flows vastly outweighs their fickleness cost when there is a shortage of safe assets. Capital flows are more useful and greater in magnitude when the global correlation of liquidity shocks is lower. Taxing capital flows, while could prove useful for a country in isolation, backfires as a global equilibrium outcome. However, if the system is heterogeneous and includes economies with abundant (DM) and with limited (EM) natural domestic liquidity, there can be scenarios when global uncertainty is high and EM's reach for safety can destabilize DMs, as well as risk-on scenarios in which DM's reach for yield can destabilize EMs.