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Financial Liberalization and Consumption Volatility in Developing Countries

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  • Andrei A. Levchenko

    (International Monetary Fund)

Abstract

One of the chief benefits of financial liberalization proposed by theoretical literature is that it should allow countries to better smooth consumption through international risk sharing. Recent empirical evidence does not support this prediction. In developing countries, financial liberalization seems to be associated with an increase in consumption volatility. This paper seeks to rationalize the evidence by linking it to two important features of developing countries. First, domestic financial markets are underdeveloped. We model this by adopting the Kocherlakota (1996) framework of risk sharing subject to limited commitment. Second, access to international markets is not available to all members of society. We show that when risks are idiosyncratic, that is, insurable within the domestic economy, opening up to international markets reduces the amount of risk sharing attained at home and raises the volatility of consumption. When risk is aggregate to the economy, the underdeveloped financial system prevents the pooling of aggregate risk across agents for the purposes of insurance in the international markets. Thus, while the volatility of consumption coming from aggregate risk decreases with financial liberalization, it does so by much less than would be predicted by a representative agent model.

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Bibliographic Info

Article provided by Palgrave Macmillan in its journal IMF Staff Papers.

Volume (Year): 52 (2005)
Issue (Month): 2 (September)
Pages: 237-259

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Handle: RePEc:pal:imfstp:v:52:y:2005:i:2:p:237-259

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  1. Acemoglu, Daron & Zilibotti, Fabrizio, 1996. "Was Prometheus Unbound by Chance? Risk, Diversification and Growth," CEPR Discussion Papers 1426, C.E.P.R. Discussion Papers.
  2. Narayana Kocherlakota, 2010. "Implications of Efficient Risk Sharing Without Commitment," Levine's Working Paper Archive 2053, David K. Levine.
  3. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, vol. 64(2), pages 261-94, March.
  4. Bekaert, Geert & Harvey, Campbell R. & Lundblad, Christian, 2006. "Growth volatility and financial liberalization," Journal of International Money and Finance, Elsevier, vol. 25(3), pages 370-403, April.
  5. Obstfeld, Maurice, 1994. "Risk-Taking, Global Diversification, and Growth," American Economic Review, American Economic Association, vol. 84(5), pages 1310-29, December.
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  7. Graciela L. Kaminsky & Carmen M. Reinhart, 1996. "The twin crises: the causes of banking and balance-of-payments problems," International Finance Discussion Papers 544, Board of Governors of the Federal Reserve System (U.S.).
  8. Xavier Gabaix, 2009. "The Granular Origins of Aggregate Fluctuations," NBER Working Papers 15286, National Bureau of Economic Research, Inc.
  9. Timothy J. Kehoe & David K. Levine, 2000. "Liquidity Constrained vs. Debt Constrained Markets," Levine's Working Paper Archive 14, David K. Levine.
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