Lecture 8 - Sara - The benefits from financial globalisation: risk sharing Flashcards
what are the two cases of financial market intergration?
financial autarky and financial openness (full intergration)
what is a financial autarky?
if countries are in a financial autarky, they cannot trade assets which could potentially serve to insure against the country specific shock. in financial autarky: consumption= output in every period and in every state of nature
why would countries prefer the consumption allocation under financial intergration?
this has to do with the concavity of the utility function. in other words, people like to smooth their consumption (do not like extremes)
demonstrate using the example of apples why financial intergration is convenient for both countries?
assume that in date 1 each country has two apples. on Date 2, state 1 is where UK has one apple and US has three , in state two the UK has three whilst the US has 1. now assume there are two assets availiable for the countries to trade. asset 1 paus one unit of output in case state 1 is realised and nothing if state 2 is realised and asset 2 pays one unit of output in the case state 2 is realised and nothing if state 1 is realised. on date 1, the US and UK would agree on the following transactions (if it was rational to do so. UK has an incentive to buy asset 1 as they are relatively poor in state 1. the US would then sell asset to UK and would have to payout one apple if state 1 occurs.the US have the incentive to buy the asset 2 as they are relatively poor in state 2 and so UK would sell this to the US and will pay one apple if state 2 occurs. The UK would find beneficial to sell asset 2 and with the funds received it would buy asset 1, the US would find it beneficial to sell asset 1 and with the funds received it would buy asset 2.so with financial intergration 2 apples is guarenteed for both countries
what is the methodology for calcualting the welfare gains from international risk sharing?
calculate the equilibrium paths under financial autarky
and under financial integration under reasonable parameter values
(calibration) and then compute the welfare gains using a utility-based
measure of welfare (Hicksian equivalent variation).
what is the main result from the welfare gains from international risk sharing?
Although the result depends a lot on model-specific features, the consensus in the literature is that the welfare gains from
international risk sharing are rather small.
what were the main points of the most recent reassessment of the welfare gains couerdacier et al. (2020)
▪ They argued that the literature abstracts from the output effect of financial
integration as they only consider endowment economies (as in our simple
model).
▪ So they examined the gains of financial integration in a model that features
both the capital reallocation (lecture 2) and the risk sharing channel (this
lecture), while allowing for incomplete markets (where only riskless bond
can be traded).
▪ But they find a permanent increase in consumption from international
financial integration of only 0.5%
what is the conclusion of the general model
u’(C_2uk(s))/u’(C_1uk) =u’(C2_us(s))/u’(C_1us) where s={1,2} and utility functions are logarithmic ?
consumption growth is the same across countries for risk sharing countries. they may be different for financial autarkys
what is the testable implication on the consumption growth rate being the same across countries which risk share and what is the evidence for this implication?
If countries are sharing risk efficiently, then consumption across countries should be more correlated than output. there is a lack of empiracle evidence between output and consumption
why is risk sharing worse for developing countries?
risk sharing is worse for developing counries is due to sovereign risk. Sovereign risk is the potential that a nation’s government will default on its sovereign debt by failing to meet its interest or principal payments.
what is one of the explanations behind the lack of consumption correlations?
One of the explanations behind the lack of consumption correlations is that
risk involving non-tradable goods (which can be a big chunk of aggregate
output) cannot be shared internationally by definition.
conclusions from the benefits of financial intergration with relation to risk sharing?
Access to international financial markets allows countries to share risks
e.g. selling assets to decrease consumption in states where output is
high and buying assets to increase consumption in states where output
is low.
▪ Consumption smoothing implies that consumption across countries
should be more correlated than output.
▪ But this is not the case, so there is little evidence of risk sharing going on,
across even developed countries.
▪ But even if financial markets were more sophisticated than they are and
countries actually engaged in more risk sharing, the welfare literature
highlights that the benefits of doing so would be small anyway
