The paper presents a two-country real business cycle model with a financial sector that intermediates portfolio flows. It is changes in demand for nancial assets from foreign investors relative to domestic investors that gives rise to portfolio flows. The simulations show that portfolio flows to emerging markets respond negatively to global risk in line with findings from the empirical literature. The transmission channel that links portfolio flows to credit in emerging markets is the financial intermediary’s demand for deposit liabilities (demand for savings).
One can avoid the transmission by absorbing the shock before it affects the intermediary’s demand for savings. The results show that financial shocks (eg: risk) can be absorbed by optimal changes in the supply of risk free assets. Real shocks (eg: income) can be absorbed by keeping the supply of financial assets fixed and instead allowing the prices to adjust to demand. Macroprudential regulation that limits the total risk exposure of the financial sector increases the volatility of portfolio flows, but reduces the volatility of consumption and labour and therefore increases welfare. Volatility in the composition of the balance sheet (portfolio flows), does not necessarily increase volatility in the aggregate size of the balance sheet (savings). The model uses a risk-constraint on bank balance sheets as a tool to ensure less-than-perfect elasticity of demand for financial assets. The elasticity of demand is important because it determines the size and direction of portfolio
flows.