In this section we consider a variant of our model that introduces a "storage technology", namely a technology that provides the economy with a safe store of value—this technology has a lower mean return than entrepreneurial activity, but entails no risk. We further assume that this storage technology is better in the North than in the South. What we thus capture with this variant is the idea that the less developed countries may have a relative shortage of safe assets, due to weaker enforcement of property rights. As mentioned in the Introduction, this builds a bridge between our paper and that of Caballero, Farhi and Gourinchas (2008).
To focus on this possibility, we now assume that the countries do not differ in the amount of risk in their "entrepreneurial sector": σ˜1 = ˜σ2.Instead, the North is now identified solely by its ability to access a better storage technology. This storage technology can also be interpreted as a sector in which all idiosyncratic risks are diversified—think of this as the "public equity sector".12 The
12However, see Panousi and Papanikolaou (2009) for some evidence that idiosyncratic risks are relevant for invest-ment decisions even within the public-equity sector.
production function in the storage technology has the form gj(Mjt) =A1−αj Mjtα, where Mjt is the level of capital in the safe sector, andAjdetermines the size of the public or safe sector relative to the size of the private or risky sector. Therefore total aggregate capital isKjttotal =Kjt+Mjt, aggregate financial wealth is Xjt =Kjt+Mjt+Bjt, and aggregate wealth isWjt =Kjt+Mjt+Bjt+Hjt. The storage technology provides a safe asset in positive net supply in the autarchic economy, while agents still have access to the bond, which is a safe asset in zero net supply in autarchy. The key assumption here is thatA1> A2, meaning that the South can create safe assets at a lower efficiency than the North.
Clearly, in equilibrium the risk-free rate must satisfy Rt = gj′(Mt) for country j. This pins down the stock of safe assets in the South as an increasing function of the interest rate. The rest of the equilibrium characterization then proceeds in similar lines as in our benchmark model. In particular, the general-equilibrium dynamics under either autarchy or integration are given by the following, which is a direct adaptation of Proposition 1 to the introduction of a storage technology for each country. The analysis of such a variant, as well as the quantification of our mechanism, is left for future work.
Proposition 4. In either the autarchic or the integrated equilibrium, the aggregate dynamics of country j satisfy the following ODE system
Cjt+ ˙Kjt+ ˙Mjt+ ˙Bjt =f(Kjt)−δKjt+gj(Mjt)−δMjt+RjtBjt C˙jt
Cjt =θ(ˆρjt−β) +12γσ˜2jφ2jt H˙jt=RjtHjt−(1−α)f(Kjt)
Bjt = (1−φjt)(Kjt+Bjt)−φjtHjt Rjt=gj′(Mjt)
where φjt =φ(Kjt, Rjt,σ˜j) and ρˆjt = ˆρ(KjtRjt,σ˜j). The autarchic equilibrium is then obtained by letting R1t6=R2t and requiring that, for each j,Rjt adjusts so that
Bjt = 0. (21)
In contrast, the integrated equilibrium is obtained by imposing R1t = R2t = Rt and requiring that Rt adjusts so that
B1t+B2t= 0 (22)
Parameters Values Preferences
β 0.05
γ 8
θ 1
Technology
α 0.40
δ 0.10
A1 0.45
A2 0
Risk
˜
σ1 0.40
˜
σ2 0.40
Table 2. Calibration Values with Storage Technology.
6.1 Calibration
The economies are now parameterized by (α, β, γ, δ, θ,σ˜1,σ˜2, A1, A2). Table 2 presents our pa-rameter choices. Here, most papa-rameters are as in our benchmark model, except for the fact that the level of idiosyncratic risk is now the same in both countries at ˜σ1 = ˜σ2 = 0.40. As anticipated, we set the level of risk to be the same in both countries in order to isolate the impact of differences in the capacity to produce safe assets. For simplicity, and without serious loss of generality, we set A2 = 0, in which case M2t= 0; that is, we take the extreme scenario where the South has no ability to produce safe assets. Finally, we choose A1 = 0.45, because this ensures that, at the autarchic steady state, total capital in the North is allocated equally between the two sectors of production.
This choice is somewhat arbitrary but is motivated by the experience of the United States, where about one half of the capital stock is owned by the private-equity sector and the other half by the public-equity sector.
6.2 Dynamic Responses
We now consider the dynamic response of the two economies to financial integration, starting from autarchy. The transitional dynamics once again reduce to a simple ODE system in(X1t, X2t, H1t, H2t), except that nowXjt ≡Kjt+Mjt+Bjt. The dynamics of the South are presented in Figure 5, the dynamics of the North in Figure 6. As before, time in years is on the horizontal axis, the blue lines indicate the levels of the variables at the autarchic steady state, the red lines indicate the levels of the variables at the integrated steady state, and the black lines show the dynamic response of the
variables.13
As in the baseline model, the North is richer than the South in autarchy, and features higher interest rates. However, this is not anymore because the entrepreneurial sector is riskier in the South—the entrepreneurial sectors have now been assumed to have the same risk in both economies.
Rather, it is because the safe asset is in positive supply in the North—this limits both the precau-tionary pressures on domestic interest rates and the risk premium in the entrepreneurial sector. As a result, relative to the South, the North has both a higher interest rate and a higher capital-labor ratio in the entrepreneurial sector.
The dynamic responses upon financial integration then mimic those in the baseline model. Once again, the short run looks bleak for the South, with an outflow of capital to the North. But as the Southerners get richer over time by getting access to the safe assets of the North, they become more willing to undertake risk, and they return to the South in order to take advantage of the higher capital returns in the entrepreneurial sector there. Hence, in the long run the picture is reversed, and the South ends up with a higher capital stock than it had under autarchy. The opposite is true for the North.
Figures 5 and 6 present the dynamic responses of the North and the South, respectively. In the short run, aggregate capital in the South drops by −4.3%whereas in the North it increases by 1.9%. In the long run, aggregate capital in the South increases by 10.8% whereas in the North it drops by2.6%.
Interestingly, the dynamic adjustment of the economies now also features changes in the measure TFP, as capital gets reallocated between the two sectors within each country. In the North, aggregate TFP, as measured by the Solow residual,14 falls by 2.3%between the autarchic and the integrated steady state. If we had allowed for some storage in the South, the converse picture would emerge for the measured TFP of this country: its Solow residual would grow between the autarchic and the integrated steady states.
At the same time, it remains true, as in the baseline model, that the North runs current account deficits, while the South runs current account surpluses. It follows that our model can solve the empirical "puzzle" documented by Gourinchas and Jeanne (2008). This worked show that capital appears to flow from countries that experience positive higher growth to countries that experience lower productivity growth. While this fact is inconsistent with the standard neoclassical growth paradigm, it is consistent with our model.
13Note that here aggregate capital is given byKjttotal=Kjt+Mjt.
14With the amount of labor normalized to 1, the Solow residual is given by approximately SR1t ≡ ln(Yjt)− αln(Kjt+Mjt).
7 Conclusion
This paper studies the global macroeconomic implications of financial integration within a Bewley-type model that feature idiosyncratic investment, or entrepreneurial risk. The key lessons we obtained can be summarized as follows. When the South is in financial autarchy, the domestic (risk-free) interest rate is depressed relative to the North because of a strong precautionary demand for saving. Upon financial integration, some of the South’s precautionary saving can find outlet in the North—thus giving rise to global imbalances and also raising the interest rate in the South.
This increase in the interest rate increases the opportunity cost of capital, implying a reduction in investment and output in the South. However, as time passes, agents in the South accumulate more wealth due to the higher safe returns they now enjoy in the North. In the process, they become more willing (or able) to engage in risky entrepreneurial activities or otherwise to invest in high-return, but risky, domestic investment opportunities. This in turn opens the door to a “reversal of fortune” in the long run: while capital initially flows out of the South, it starts flowing back after some transitional period, eventually leading to higher output, wages, and consumption than under autarchy. Our paper therefore provides not only an explanation of global imbalances, but also a distinct input to the ongoing debate on the costs and benefits of capital account liberalization.
Furthermore, because the aforementioned transition in the South may feature a reallocation of capital from safe but low-return activities to risky but high-return ones, measured TFP in the South may increase along the transition. Conversely, the North may experience a drop in TFP (or a lower growth rate than the South). Along with the property that the South runs current account surpluses, while the North runs current account deficits, this implies our model predicts that capital flows from the faster growing countries to the slower growing countries—a prediction that is the opposite of the one made by the standard neoclassical paradigm and that helps resolve the empirical puzzle documented by Gourinchas and Jeanne (2008).
Underlying these results were a two key properties. First, a positive wedge was present between the marginal product of capital and the risk-free rate. Second, this wedge was decreasing in wealth.
In our model, the first property was due to undiversified idiosyncratic risk and the second due to deminishing absolute risk aversion. However, these properties may also emerge in models with borrowing constraints: these models typically feature a positive wedge between the marginal product of capital (internal returns) and the interest rate faced by savers (external returns), but this wedge vanishes as wealth increases and the borrowing constraint is overcome. We thus conjecture that similar results would obtain in a variant of our model that would introduce borrowing constraints on investment/entrepreneurial activity.
Appendix
Proof of Lemma 1 (individual policy rules). This result is essentially a variant of the Merton-Samuelson optimal portfolio problem; see also Proposition 1 in Angeletos and Panousi (2009).
Proof of Proposition 1 (equilibrium dynamics). For simplicity, we drop the index j.
Since aggregate labor demand is R
init= ¯n(ωt)Kt and aggregate labor supply is 1, the labor market clears if and only if n(ω¯ t)Kt= 1.It follows that the equilibrium wage satisfies ωt=FL(Kt,1)and, similarly, the equilibrium mean return to capital satisfiesr¯t=FK(Kt,1)−δ.The bond market, on the other hand, clears if and only if Bt= 0, or equivalently (1−φt)Wt−Ht = 0. Combining this withKt=φtWtgives condition (17).
Combining the intertemporal government budget with the definition of human wealth, we get Ht=ht=
Z ∞ t
e−RtsRjdj(ωs−Gs)ds. (23) Expressing this in recursive form gives condition (16).
Let ρ¯t ≡φtr¯t+ (1−φt)Rt denote the mean return to total saving. Aggregating the household budgets givesW˙t= ¯ρtWt−Ct.Combining this with (16) and with Kt+Ht=Wt, we get thatK˙t= W˙t−H˙t= (¯ρtWt−Ct)−(RtHt−ωt+Gt).Usingρ¯tWt= ¯rtφtWt+Rt(1−φt)Wt= ¯rtKt+RtHt, we getK˙t= ¯rtKt+ωt−Ct−Gt.Together with the fact, in equilibrium,¯rtKt+ωt=F(Kt,1)−δKt, this gives condition (14), the resource constraint.
Finally, using Ct=mtWt,and therefore C˙t/Ct= ˙mt/mt+ ˙Wt/Wt together with W˙t= ¯ρtWt− Ct= (¯ρt−mt)Wt and (10), gives condition(12), the aggregate Euler condition.
Proof of Lemma 2. (i) The form of the function K is evident from condition (16), while the form of the function B follows from condition (17).
(ii) Since K(R) =hµ(R)+δ+R
α
iα−11
, it follows that KR has the same sign as α−11 (µR+ 1). Since µ(R) = (2θγ1+θσ˜2(β−R))1/2, we get that µR = (−122θγ˜1+θσ2)1/2(β−R)−1/2. Using this, we have that KR>0⇔R > β−12θγ˜θ+1σ2 ≡R(˜ˆ σ)˜ < β≡R.¯
In addition, since W˙t = ¯ρtWt−Ct = (¯ρt−mt)Wt, wealth stationarity requires ρ¯= m. Com-bining this with the Euler equation in steady state, we get
θ+ 1
2 φ(f′(K)−δ−R)−θ(β−R) = 0.
From this, and for steady-state capital to be lower than under complete markets, that is, forf′(K)−
δ > β, it has to be the case that bothφ(0) andK(0) are finite. It follows that
R→0lim+B(R) =−(1−α)K(0)α lim
where we suppress the dependence ofK, µ,and φonR for notational simplicity. It follows that
∂B
(v) Using the formulas for µ(R)and φ(R)from above, we get
Proof that the first part of Assumption 1 implies its second part. For simplicity, we drop the index j. After some algebra using the definitions ofRˆ and R
¯, we get
Proof of Proposition 2. (i) This part follows from the proof of Lemma 2, part (iii). The limits of B(R), together with the continuity of B(R) in R, establish the existence of an R that solvesB(R) = 0.This is in fact the unique steady-stateR, since BR>0 always.
(ii) The equation B(Rautj ,σ˜j) = 0 is simply bond market clearing for each country. Under Assumption 1, we are in the region where Bσ˜ >0. From(1)we have thatB=B/K ≡D. Using a proof similar to that in Proposition 1(iv), we get thatDR<0. Hence, BR<0. We also have that Bσ˜ =BRRσ˜ > 0, with BR < 0. Therefore, it has to be that R˜σ <0 in autarky. In other words, R1aut> Raut2 .
(iii) Under Assumption 1, we are in the region where KR>0. Hence, the fact thatRaut1 > R2aut implies that K1aut > K2aut > 0. Since consumption is increasing in capital, we also have that C1aut> C2aut.
Proof of Proposition 3. (i) Consider the functionWB(R) defined by WB(R)≡B(R,σ˜1)K(R,σ˜1) +B(R,˜σ2)K(R,σ˜2)
An integrated steady state is given by any solution to WB(R) = 0. Note that the function K is always positively valued, while the function B can take both signs and is increasing in R and ˜σ.
Furthermore, recall that Raut2 < Raut1 . Whenever R ≤ Raut2 (< Raut1 ), by the monotonicity of B in R we have that B(R,σ˜2) ≤ B(R2aut,σ˜2) = 0 and B(R,σ˜1) < B(Raut2 ,σ˜2) = 0; it follows that WB(R)<0. Similarly, wheneverR ≥Raut1 , we have thatWB(R) >0. Along with the fact that the function WB(R) is continuous in R, this implies that a solution Rint to WB(R) = 0 always exists and it necessarily satisfies Raut2 < Rint< Raut1 .
(ii) Since Kσ˜ <0, it follows thatK1int> K2int, Since Assumption A1 ensures thatKR>0, and using (i), we get the desired result.
(iii) Under Assumption A1, we are in the area where B˜σ >0, which implies that Bint1 < B2int, and since the world bond market has to clear, this means that B1int<0< B2int.
(iv) This part follows directly from parts (ii) and (iii).
Proof of Proposition 4 (storage). This follows from a direct adaptation of Proposition 1, replacingBjt withBjt+Mjt in all the conditions of this proposition and adding the new optimality conditionRjt =g′j(Mjt).
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0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045
−1200
−1000
−800
−600
−400
−200 0 200
B
R
Raut
1
β B2
B1
Raut
2
Figure 1: Autarchic Steady States. The interest rate is on the horizontal axis. The blue line is the function B(R) for the North. The green line is the function B(R) for the South. The intersection of the B(R)-curves with the red zero line gives the autarchic interest rates, where Raut2 < Raut1 .
0 50 100 150 200 250 t
Figure 2: Dynamics of the South. Time in years is on the horizontal axis. The economies are integrated at time zero. The blue line indicates the value of the variables in the autarchic steady state. The red line indicates the value of the variables in the integrated steady state. The black line indicates the dynamic path of the variables. Capital, output, consumption, and the wage are normalized by the corresponding autarchy values of the North. The net foreign asset position is given as a fraction of GDP.
0 50 100 150 200 250 t
Figure 3: Dynamics of North. Time in years is on the horizontal axis. The economies are integrated at time zero. The blue line indicates the value of the variables in the autarchic steady state. The red line indicates the value of the variables in the integrated steady state. The black line indicates the dynamic path of the variables. Capital, output, consumption, and the wage are normalized by their corresponding autarchy values. The net foreign asset position is given as a fraction of GDP.