International Financial Integration and the Real Economy

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Abstract: What are the consequences of financial integration for the real economy? This paper develops a set of theoretical benchmarks for the link between integration and macroeconomic volatility and welfare. The analysis is conducted in a standard two-sector international real business cycle model in which we introduce dynamic portfolio choice over equities and an international bond. The model predicts an increase in the volatility of output in response to integration, whereas the relationship between integration and consumption volatility is hump-shaped. We also find that financial integration is associated with significant improvement in risk-sharing across countries, although in aggregate the welfare benefits are very small. At the same time, the level of financial integration significantly affects how the welfare benefits of productivity shocks are distributed internationally. [JEL D52, F36, G11]