Series: Working Papers. 1038.
Author: Francesca Viani.
Full document
Abstract
Whether cross-border financial market integration has raised global insurance, is still
a controversial issue in the literature. If this is so, what should we observe in the data?
The insurance literature emphasizes that efficient risk-sharing requires financial markets to
channel resources to countries that have been made temporarily poorer by some negative
conjuncture, net of physical capital accumulation. This standard condition, which provides
the basis for virtually every test of international insurance, is however derived focusing
on only one of the two channels of cross-border insurance, the financial flows channel,
implicitly assuming no interaction between this and the other channel, international relative
price fluctuations.
This paper shows that testable conditions can only be derived theoretically placing the
interaction between prices and financial flows centerstage in the analysis. Using a twocountry
general equilibrium model with endogenous portfolio diversification, I show that
financial flows and relative prices can be either complements or substitutes in providing
insurance. In the case of complementarity, financial inflows raise the international price
of a country´s output. This implies the standard condition. In the case of substitutability
prices and flows transfer purchasing power in opposite directions. This implies a different
condition: efficient financial markets are required to channel resources «upstream», from
relatively poorer to relatively richer countries. The conditions for substitutability appear to be
quantitatively and empirically plausible.