Hot Money and External Adjustment

Abstract

This paper studies the behavior of international capital flows driven by the portfolio reallocation decisions of international investors; so-called hot money. I develop an open economy model with endowment and preference shocks that can account for the empirical behavior of real exchange rates, interest rates and consumption in the U.S. and Europe. The model includes financial frictions that impede international risk-sharing and hot money flows driven by optimal portfolio reallocations. My analysis reveals that hot money flows are an economically insignificant part of the international adjustment process following standard (temporary) endowment shocks. In contrast, preference shocks that change investors’ risk aversion produce sizable hot money flows. These shocks also produce sizable variations in the expected return differentials on foreign assets and liabilities that allow for external adjustment via the valuation channel. Consistent with the model’s predictions, I show that forecasts of future return differentials contributed most to the volatility of the U.S. net foreign asset position in the post Bretton-Woods era. Together, these findings indicate that hot money flows are an integral and empirically important part of the external adjustment process.