Incomplete Markets and Trade Incomplete Markets and Trade

November 1, 2010

Motivation for the Research
Researchers have recently documented significant differences in the structure and function of financial markets across countries. Much of this research explores how such differences can affect the level and growth of economic activity, but little addresses the subject of this paper: how financial markets affect the balance of trade in goods across countries.

Research Approach
The author employs a two-period, exponential-normal, general-equilibrium model with incomplete markets and with countries composed of heterogeneous households. The assumptions of exponential utility and normally distributed endowments and asset payoffs, common in the literature, allow for analytical solutions (but also lead to well-known shortcomings, chief among them being an implication of exponential utility: that absolute tolerance for risk is unaffected by the level or variance of consumption).

Key Findings

  • Incomplete markets lead to trade imbalances. Among countries that would engage in balanced trade if markets were complete, trade imbalances emerge when some markets are absent.
  • When markets are incomplete across countries-that is, when risky assets do not span national income-for a small, open economy, the more highly correlated national income is with internationally traded risky assets, the lower is the trade deficit.
  • Even when markets are complete across countries, market incompleteness within countries- that is, when assets do not span all individual household income streams-can still lead to trade imbalances.
  • Countries with more-complete markets run trade deficits with countries with lesscomplete markets.
  • The more national income is spanned by risky assets, the smaller is a country's trade deficit with the rest of the world.
  • The paper contributes to the theory of international trade in financial assets and to the theory of incomplete markets by (1) extending Svensson's laws of comparative advantage for international trade in assets to economies with heterogeneous agents and (2) showing that the R2 of a regression provides a useful measure of market incompleteness both for countries and for individuals.

The theory discussed in the paper leads to several potentially testable propositions. As mentioned above, researchers have developed measures of financial development, and one could explore the relationship between these measures and trade imbalances. It is worth noting that the United States, with the most sophisticated capital markets in the world, has more-complete markets than any other country. Thus, the fact that the United States also runs large trade deficits is consistent with the theory. On the other hand, the existence of large U.S. trade deficits is inconsistent with the finding that the more national income is spanned by risky assets, the smaller is a country's trade deficit.

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