Financial Integration and Capital Accumulation

How does financial integration impact capital accumulation when countries differ in the efficacy of internal financial markets? We examine this question within a two-country incompletemarkets model featuring a specific financial friction: agents face uninsurable idiosyncratic risk in their investment, or entrepreneurial, opportunities. Under financial autarchy, the South (the country with the least developed risk-sharing possibilities) features a higher precautionary motive for saving and a lower risk-free rate, but also a lower capital stock and lower output. Upon financial integration,capital flies out of the poor, capital-scarce South, causing a prolonged deep in domestic activity. At the same time, the rich, capital-abundant North runs large currentaccount deficits and enjoys a prolong boom. However, these effects are more than reversed in the long run: as time passes, capital starts flowing back into the South, eventually leading to higher domestic activity than under autarchy. Taken together, these results help explain the emergence of global imbalances while also providing a distinct policy lesson regarding the intertemporal costs and benefits of financial integration.