A Pedagogical Note on Risk Sharing Versus Instability in International Financial Integration: When Obstfeld Meets Stiglitz
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The pure risk sharing mechanism implies that financial liberalization is growth enhancing for all countries as the world portfolio shifts from safe low-yield capital to riskier high-yield capital. This result is typically obtained under the assumption that the volatilities for risky assets prevailing under autarky are not altered after liberalization. We relax this assumption within a simple two-country model of intertemporal portfolio choices. By doing so, we put together the risk sharing effect and a well-defined instability effect. We identify the conditions under which liberalization may cause a drop in growth. These conditions combine the typical threshold conditions outlined in the literature, which concern the deep characteristics of the economies, and size conditions on the instability effect induced by liberalization.
KeywordsEconomic growth Financial liberalization Risk sharing Volatility Emerging markets
JEL ClassificationF21 G15 O16 O41
We thank three anonymous referees for their careful reviewing. Geert Bekaert, Fausto Gozzi and Patrick Pintus are gratefully acknowledged for useful discussions.
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