The Effects of Goods and Financial Market Integration on Macroeconomic Volatility

Abstract

The aim of this work is to determine whether increasing goods and ¢nancial market integration raises or lowers macroeconomic volatility. Shocks to money, government expenditure, and labour supply are analysed under di¡erent degrees of goods and ¢nancial market integration in a dynamic general equilibrium framework. Simulations show that the e¡ects of the di¡erent shocks on economic volatility change signi¢cantly depending on the presence of incompletely integrated goods and/or ¢nancial markets. However, the results suggest that the e¡ect of integration in one market is largely independent of the extent of integration in the other market. " IntroductionGiven the importance of market integration in Europe and the concern for macroeconomic stabilization, it is important to determine whether integration raises or lowers macroeconomic volatility in the face of economic disturbances. In this paper goods and ¢nancial market integration are modelled and changes in the stabilizing roles played by di¡erent macroeconomic variables in response to disturbances to the economy under di¡erent degrees of goods and ¢nancial market integration are investigated.The paper will extend theoretical models of intertemporal consumption smoothing to incorporate incomplete integration in goods and ¢nancial markets within a setting where nominal rigidities and imperfect competition exist. The theoretical framework of the model is based on the work of Obstfeld and Rogo¡ (1995) which incorporates nominal rigidities and imperfect competition into an intertemporal optimizing framework. Obstfeld and Rogo¡ assume purchasing power parity (PPP) and no impediments to trade in goods markets and integrated world capital markets. The basic objective of this paper is to extend this framework by

Toward a New Paradigm in Open Economy Modeling: Where Do We Stand?

“…With substantial price inertia, output adjusts slowly and more agents smooth their consumption pattern via international financial markets. Sutherland's simulations suggest that financial market integration increases the volatility of a number of variables when shocks originate from the money market but decreases the volatility of most variables when shocks originate from real demand or supply; these results also hold in the generalization of Sutherland's model by Senay (1998). For example, a positive domestic monetary shock induces a domestic interest rate decline and, therefore, a negative interest rate differential with the foreign country.…”

International Financial Integration and the Real Economy

“…Consider the return on h traded equity de…ned in (20). Following Campbell and Shiller (1989), we approximate the log return by…”

“…Baxter and Crucini (1995) and Heathcote and Perri (2002) …nd that the volatility of output increases with integration, but results are sensitive to the speci…cation for productivity. When nominal rigidities are introduced, Sutherland (1998) …nds that there is a general tendency for volatilities to decrease in response to higher …nancial market integration, but Senay (1998) reports mixed results for how …nancial and goods market integration a¤ect volatilities. Buch and Pierdzioch (2003) introduce frictions, such as the …nancial accelerator and transaction costs in asset trades, but …nd that the link between integration and volatility is weak and is largely una¤ected by the presence of …nancial imperfections.…”

Financial Integration and Macroeconomic Volatility

“…5 Sutherland (1996), Senay (1998), and Buch, Dopke, and Pierdzioch (2002) consider the importance of monetary and fiscal policy shocks in the context of such models. The results of these studies suggest that the impact of financial integration on the volatility of output and consumption depend on the nature of shocks.…”