The Impact of Imperfect Financial Integration and Trade on Macroeconomic Volatility and Welfare in Emerging Markets

This study examines how international integration impacts macroeconomic volatility and welfare in emerging market economies (EMEs), employing a two-country real business cycle model with constrained cross-border borrowing and imperfect access to international financial market. Parameter calibration employs 2000–2013 trade and external debt data from EMEs. The simulation shows that higher foreign debt raises output volatility, slightly reduces consumption volatility of entrepreneurs who can borrow abroad, and brings about welfare loss due to higher debt interest payments and less consumption. Households who can only save in domestic markets are largely unaffected. Restricted financial integration does not have much adverse impact when people face no other frictions domestically, suggesting the importance of domestic financial development. Higher international trade tends to be favorable for output variability, consumption smoothing, and welfare, but does not play a significant role on how cross-border borrowing affects macroeconomic volatility. The results suggest that the impacts of financial and trade integration are generally independent. It might be difficult for EMEs to achieve evident gains from greater financial integration even with high trade intensity when market imperfection exists. Increasing only trade or both types of integration together can be Pareto improving that lowers aggregate fluctuation, whereas increasing only private external debt is not.