Integration, contagion, and income distribution

Abstract

The 2008/2009 global financial crisis and the unprecedented policy response in advanced economies have a worldwide impact. The episode also led many to question the standard framework of economic thinking on regional integration, financial liberalization and their repercussions on income disparity. The paper argues that one needs to take a balanced view on integrationnot just the benefits but also the risks. If regional integration leads to greater inequality, the expected growth and prospect of improved welfare can be diminished. Utilizing a general equilibrium framework, it is also shown how financial liberalization and the surge of capital inflows can produce not only financial instability but also worsening income disparity. By combining model-based results and theory-based ranking applied to the Asian case, and considering the benefits, opportunities, costs and risks of alternative policies, it is revealed that imposing levy on bank-led flows can be used to reduce instability and inequality. This type of macro-prudential policy reflects a departure from the first best to the second Best approach of liberalization, where the frictionless outcome of the former is seriously questioned.