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Unformatted text preview: Department of Economics University of California, Berkeley Spring 2006 Economics 182 Suggested Solutions to Problem Set 6 Problem 1: International diversification Because raspberries are nontradable, asset swaps or intertemporal trade cannot be used to reduce the riskiness associated with their production. Hence, differently from the example in which just tradable kiwis are produced, we cannot eliminate all the risk in the economy (unlike the example in the book, the world now is a risky place in the aggregate). So, any swap of assets (Home and foreign land) or intertemporal trade (current account surpluses or deficits) will necessarily be the consequence of the countries willingness to share the risks associated with the productions of kiwis. On the other hand, the GNP of both Home and Foreign is now composed not only by kiwis but also by raspberries. Therefore, we can say that, relative to GDP, the international asset trade is smaller. Problem 2: Measuring financial integration (a) When there is great financial integration, capital is free to move across borders and flows to places where profitable opportunities are larger. These capital movements tend to equalize real interest rates around the world. However, real interest rates might still be different for reasons related to differences in risk or institutional differences, so the equality of real interest rates will not happen even in a fully financially integrated world. (b) The volume of capital flows is somewhat unsatisfactory because it gives no indi- cation of the composition or quality of capital flows. Foreign direct investment is very different, and implies a different level of integration, than simple portfolio investment. Also, they may conceal important considerations in considering fi- nancial integration. The volume of capital flows do not tell us whether there are restrictions on the type of capital we are allowed to hold (i.e., foreign ownership of infrastructure, energy, or financial services companies is often limited) or what restrictions there are in transferring capital from one country to another. (c) With full financial integration and mobility of capital flows, we expect the corre- lation between saving rates and investment rates to be close to zero. In contrast, a coefficient close to 1 indicates that capital markets are not doing a good job in allocating capital (that there is not much mobility of capital such that financ- ing is available wherever the return is more profitable). One might think that this occurs due to financial controls or barriers on the international movement of capital. However, this high positive correlation remains even as world financial markets become more and more integrated. This again indicates that capital flows are smaller than what we expect based on the benefits we think they would 1 offer. The puzzle therefore is that, given that the capital flows are low, there are foregone gains (in international risk-sharing for example) from the potential trade...
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