Abstract
Abstract In this paper, we employ a portfolio approach based on a two-country world to study the impact of financial openness on the size of government and on other key economic variables, including the consumption-wealth ratio, the growth rate of wealth, and welfare (assuming that public spending is utility enhancing). The model suggests that the size of government, the consumption-wealth ratio, and welfare should be greater in an open economy because of higher productivity and/or less volatility because of risk sharing. The theoretical results for the growth rate depend on differences in productivity and in consumption-wealth ratios. The empirical evidence — based on a sample of 49 countries from 1970 to 2009—broadly supports the main theoretical results of the model.
Highlights
The current economic and financial crisis has reignited fundamental concerns about financial integration
We use a portfolio approach based on a two-country world to analyze the impact of financial openness on the size of government and other key economic variables, including the consumption-wealth ratio, the growth rate of wealth, and welfare
The theoretical model suggests that both the size of government and the consumption-wealth ratio should be greater in an open economy than in a closed economy
Summary
The current economic and financial crisis has reignited fundamental concerns about financial integration. In contrast to the largely positive perception of trade integration, economists differ sharply about the effect of financial integration on growth.” These doubts apply to the impact of financial openness on the size of government in the global economy. We depart from the work of Turnovsky (1999) by seeking to address both gaps, i.e., the absence of a convenient theoretical framework to explicitly analyze the impact of financial openness on the size of a utility-enhancing government in a two-country world economy, and the absence of a coherent analysis of the empirical evidence based on the model proposed in the paper. Financial integration allows an open economy to diversify some of its country-specific risk and achieves less volatility, which implies a reduction in savings and an increase in private consumption This combined effect suggests that the consumption-wealth ratio should be higher in an.
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