Can Sticky Portfolios Explain International Capital Flows and Asset Prices?

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Over the past decade portfolio choice has become an important element of many DSGE open economy models. However, there is a substantial body of evidence that 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 what level of portfolio frictions is most consistent with the data and the impact of portfolio frictions on asset prices and net capital flows. We find that the portfolio friction can account 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 observed fundamentals, (iii) a broad set of moments related to the time series behavior of saving, investment and net capital flows, and (iv) phenomena such as excess return momentum, reversal and post-earnings announcement drift. For a plausible level of the friction, financial and saving shocks each account for close to half of the variance of net capital flows.