Finance and Economics Discussion Series

Financial Integration, Entrepreneurial Risk and Global Dynamics

Vasia Panousi and George-Marios Angeletos
2010-54

Abstract: How does financial integration impact capital accumulation, current-account dynamics, and cross-country inequality? This paper investigates this question within a two-country, general-equilibrium, incomplete-markets model that focuses on the importance of idiosyncratic entrepreneurial risk---a risk that introduces, not only a precautionary motive for saving, but also a wedge between the interest rate and the marginal product of capital. Our contribution is then to show that this friction provides a simple explanation for the emergence of global imbalances, a simple resolution to the empirical puzzle that capital often fails to flow from the rich or slow-growing countries to the poor or fast-growing ones, and a distinct set of policy lessons regarding the intertemporal costs and benefits of capital-account liberalization.

Keywords: Financial integration, capital-account liberalization, incomplete markets, idiosyncratic risk, entrepreneurship, current-account deficits, global imbalances