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Financial Integration, Credit Market Imperfections and Consumption Smoothing

  • Asli Leblebicioglu

    ()

    (Economics North Carolina State University)

Recent empirical research by Kose, Prasad and Terrones (2003) shows that financial integration is associated with higher consumption volatility in developing countries. This paper provides one possible explanation as to how international financial integration can increase consumption volatility in a developing country facing credit market imperfections. I use a two country international real business cycle model where the non-traded sector in the small country faces borrowing constraints due to contract enforceability problems. Financial integration provides households insurance against domestic risks that are amplified by the financial imperfections. If the international risk-sharing opportunities are nonexistent, households can secure themselves only by adjusting their labor effort, which leads to changes in sectorial output and terms of trade. The deterioration of the terms of trade acts as a dampening effect on consumption, causing it to be less volatile under financial autarky relative to financial integration

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 651.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:651
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