Macroeconomic and Welfare Implications of Financial Globalization

It is well documented that since the mid-1980s there has been a surge in capital flows due to an increased integration of world financial markets. Absent limited commitment, the increase in financial linkages should improve risk-sharing opportunities and foster consumption smoothing. However the data show that for several countries financial liberalization leads to enhanced consumption volatility. This fact can be rationalized using a small open economy model where foreign lending to households is constrained by a borrowing limit motivated by limited enforcement. Borrowing is secured by collateral in the form of durable investment whose accumulation is subject to adjustment costs. In this economy an increase in the degree of capital account liberalization increases consumption volatility (even relative to output volatility) as agents are unable to exploit risk-sharing opportunities. In presence of risk averse agents an increase in financial integration reduces welfare