Volatility and the Welfare Costs of Financial Market Integration

42 Pages Posted: 29 Nov 1998 Last revised: 15 Jul 2022

See all articles by Pierre-Richard Agenor

Pierre-Richard Agenor

The University of Manchester - School of Social Sciences

Joshua Aizenman

University of Southern California - Department of Economics

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

The University of Manchester - School of Social Sciences ( email )

Oxford Road
Manchester, M13 9PL
United Kingdom

Joshua Aizenman (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

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