Impact of Risk Aversion on Optimal Market Integration

Abstract

This paper examines the equilibrium growth rate of capital stock and social welfare under an infinite-horizon economy with productivity shocks. The analysis is conducted in an international context where the volatility of production is assumed to be endogenously determined by the degree of market integration. The evidence suggests that when risk aversion is high, endogenous productivity risks can induce precautionary savings and the over-accumulation of capital stock, whereas spillovers from integrated markets are conducive to the under-accumulation of capital stock. Only in this case does a unique equilibrium exist in which partial market integration contributes to growth and social welfare. When risk aversion is low, there exist multiple equilibria depending on the degree of market integration, and full market integration is desirable for social welfare. The model gives an explanation of the withdrawal of the United Kingdom from the European Union as an example of rational market participation decisions.