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Medium and long term implications of financial integration without financial development

Flavia Corneli ()

No 1120, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: We show that, in a two-country model where the two economies differ in their level of financial market development and initial capital endowment, financial integration has sizeable transitory as well as permanent effects. We confirm that, consistent with the Lucas paradox, financial integration in the medium term can reduce capital accumulation and increase savings in the financially less developed country, characterized by domestic capital market distortions, due to a higher risk premium in production activities. In the long run, however, integration produces higher levels of capital than in the autarky steady state. The opposite happens to the financially advanced economy, where integration initially boosts consumption and leads to a lower saving rate, and in the long run causes a reduction in capital compared with the autarky steady state. Two forces drive these results: precautionary saving and the propensity to move resources from risky capital to safe assets until the risk-adjusted return on capital equalizes the risk-free interest rate; assuming a constant relative risk aversion (CRRA) utility function, these forces are both decreasing in wealth.

Keywords: financial integration; international capital movements; incomplete markets; economic growth (search for similar items in EconPapers)
JEL-codes: F36 F43 G11 O16 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-fdg and nep-upt
Date: 2017-06
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