Volatility and the Welfare Costs of Financial Market Integration

42 Pages Posted: 29 Nov 1998  

Pierre-Richard Agenor

University of Manchester - School of Social Sciences

Joshua Aizenman

National Bureau of Economic Research (NBER)

Date Written: November 1998

Abstract

This paper examines the effect of volatility on the costs and benefits of financial market integration. The basic framework combines the costly state verification model and the contract enforceability approach. The welfare effects of financial market integration are assessed by comparing welfare under financial autarky and financial openness -- under which foreign banks, characterized by lower costs of intermediation and a lower markup rate, have free access to domestic capital markets. The analysis shows that financial integration may be welfare reducing if world interest rates under openness are highly volatile. The basic framework is then extended to consider the case of an upward-sloping domestic supply curve of funds and congestion externalities. It is shown, in particular, that opening the economy to unrestricted inflows of capital may magnify the welfare cost of existing distortions, such as congestion externalities or deposit insurance.

Suggested Citation

Agenor, Pierre-Richard and Aizenman, Joshua, Volatility and the Welfare Costs of Financial Market Integration (November 1998). NBER Working Paper No. w6782. Available at SSRN: https://ssrn.com/abstract=139274

Pierre-Richard Agenor

University of Manchester - School of Social Sciences ( email )

Oxford Road
Manchester, M13 9PL
United Kingdom

Joshua Aizenman (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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