The current account as a dynamic portfolio choice problem

Didier, Tatiana, and Lowenkron, Alexandre-The current account as a dynamic portfolio choice problem The current account can be understood as the outcome of investment decisions made by domestic and foreign investors. These decisions can be decomposed into portfolio rebalancing and portfolio growth components, as highlighted by theoretical models. The empirical literature draws attention to the relative importance of portfolio rebalancing to explain fluctuations in capital flows, although they do not shed light on the mechanisms behind these rebalancing effects. In this paper, we provide empirical evidence of the importance of portfolio rebalancing driven by changes in investment opportunities for the dynamics of the current account. In particular, we evaluate the predictions of a partial-equilibrium model of the current account with dynamic portfolio choices, in which portfolio rebalancing is driven by changes in expected asset returns. Focusing on the dynamics of the current account between Japan and the US, we find evidence supporting innovations in investment opportunities as an important mechanism to explain international capital flows. J. Japanese Int. Economies 26 (4) (2012) 518-541. The World Bank, 1818 H. Street, NW, MSN 18-808, Washington, DC 20433, United States; PUC-Rio, Rua Marques de Sao Vicente 225, Rio de Janeiro, RJ 22451-900, Brazil. (C) 2012 Elsevier Inc. All rights reserved.