Risk Sharing and Growth in Small-Open Economies

In this paper, we revisit the question of how domestic and foreign risks affect growth through the lens of an AK small-open economy model with risky borrowing/lending and global diversification. Wealth is allocated between domestic and foreign assets and the optimal allocation depends on both the difference in deterministic returns and the relative magnitude and correlation of domestic and foreign risks. Depending on parameters, the small-open economy may choose to either borrow from abroad, despite the fact that this is risky, or lend. In contrast to standard N-country models, whether growth is faster or slower (and whether growth is more or less volatile) compared to autarky is not entirely driven by relative risk aversion but also depends on the return and risk characteristics of domestic and foreign assets. We also show that growth volatility and mean growth have typically nonmonotonic relationships with the the levels and correlation of domestic and foreign risks. We argue that these results are in line with, and lay down some theoretical foundations for explaining the conflicting empirical results regarding the impact of international financial integration on growth and in particular threshold effects.