Financial Integration, Macroeconomic Volatility, and Welfare

Abstract

This paper studies the effects of financial integration on macroeconomic volatility and welfare. We examine a two‐sector (tradable and nontradable), two‐country world economy with production in which both stocks and bonds are traded internationally, but markets are incomplete. The effects of integration are examined by comparing the equilibrium properties of the model under three financial configurations: autarky, low integration, and high integration. The model predicts a non‐monotonic relationship between the degree of financial integration and the volatility of several macroeconomic variables. Greater integration is initially associated with more volatile consumption and output, but as integration proceeds further volatility declines. We also find that although increased integration allows for significantly greater risk sharing between countries, the improvement in welfare can be very small. (JEL: D52, E20, F41)

International Capital Flows

“…Hnatkovska (2006) apply the solution method to discuss implications for issues such as the volatility of asset prices and capital ‡ows and the magnitude of portfolio home bias. Evans and Hnatkovska (2006b) use the method to discuss the welfare implications of …nancial integration. While these are the …rst papers to tackle the di¢ cult problem of portfolio choice in typical DSGE models, the method employed is an unusual hybrid that departs signi…cantly from standard …rst and second-order solution methods commonly used to solve DSGE models.…”

“…(13)- (14) show that the returns consist of a capital gain or loss due to movements in equity prices and a dividend yield. While agents can invest in equity abroad, this entails a cost.…”

“…Similarly, a Foreign agent invests a fraction k F H;t of her wealth in Home equity, and a fraction 1 k F H;t in Foreign equity, leading to an overall real return in terms of 14 It is by now quite common to introduce such exogenous …nancial frictions. Other examples, with more detailed motivating discussions, are Martin and Rey (2004), Coeurdacier (2005) and Coeurdacier and Guibaud (2005).…”

Openness and Macroeconomic Volatility: Do Development Factors Drive Such Ambiguous Results?

“…Erturk [2], for example, shows theoretically that capital account liberalization might lead to increased macroeconomic volatility through financial flows. But not all macroeconomic indicators behave the same way: Evans and Hnatkovska [3] find that financial integration leads to an increase in output volatility, but that consumption volatility follows a "inverted U" pattern, with small welfare benefits as a result.…”

EMU, EU, Market Integration and Consumption Smoothing

“…It could do so by in-2 It should be noted also that traditional research on business cycles, with no particular focus on risk sharing, uniformly yields ambiguous results about the impact of international capital market integration via gross foreign investment on the volatility of output, and whenever this is a separate subject, on the volatility of consumption too; and these ambiguous results hold in the relevant period as well as earlier ones and for the same advanced countries that Sørensen et al (2007) and KPT (2009) treat. See Razin and Rose (1994), Sutherland (1996), Easterly et al (2000), Buch (2002) and Buch et al (2005), Evans and Hnatkovska (2007), Tharavanij (2007), and Kose, Prasad, Rogoff and Wei (2009). Further and quite significantly, when Sørensen and Yosha depart from their usual approach in joint work with Kalemli-Ozcan and compare the symmetry of shocks to incomes (GNPs) with those to output (GDPs) in the EU, they find significantly higher asymmetry of GNPs than GDPs in the group (KalemliOzcan et al (2004)).…”