Financial Integration and Macroeconomic Volatility

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.