Capital Flows, Investment, and Exchange Rates

This paper incorporates international capital flows into a two-country, monetary-general-equilibrium model of asset prices with investment and production. We use the model to calculate theoretical covariances between investment, the current account, the exchange rate, and the terms of trade.These covariances depend upon the coefficient of relative risk-aversion, the magnitude and sign of a country's net international indebtedness, other properties of tastes and technologies, and the stochastic processes on disturbances to productivity and monetary growth rates. International capital flows arise from changes in world wealth and its relative composition in foreign and domestic assets. The dynamic, stochastic relations between capital flows, exchange rates, investment, and the terms of trade are critically dependent on optimal portfolio allocations and the stochastic behavior of asset prices on international financial markets.