Trade and Financial Integration, Extensive Margin, and Income Divergence

• Main Author: ZHANG, Haiping
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2014
• Subjects: financial frictions; financial integration; income divergence; minimum investment requirement; symmetry breaking; trade integration; Finance; International Economics
• Online Access: https://ink.library.smu.edu.sg/soe_research/1590; https://ink.library.smu.edu.sg/context/soe_research/article/2589/viewcontent/05_2014.pdf
• Institution: Singapore Management University

We revisit the classical question on economic integration and income convergence in a two-sector OLG model with financial frictions and sectoral heterogeneity in minimum investment requirements (MIR, hereafter). The extensive margin of investment is a critical channel through which aggregate income may become a determinant of comparative advantage. Free trade allows the rich (poor) country to specialize partially or completely in the high-MIR (low-MIR) sector which has a high (low) return endogenously. The specialization effect interacts with the neoclassical effect, which may lead to income divergence among inherently identical countries. Similarly, financial integration may also lead to income divergence through the extensive-margin channel. We then revisit the Stolper-Samuelson theorem. Antras and Caballero (2009) show that, given cross-country and cross-sector differences in financial frictions, free trade alone cannot deliver factor price equalization, while allowing both trade and capital flows can do so. In our model, if free trade induces the rich countries to specialize completely in the high-return sector, the credit market condition changes fundamentally and so does the interest rate determination. In this case, moving from autarky to free trade does not reverse the cross-country interest rate diferentials and the direction of capital flows, and allowing both trade and capital flows does not lead to factor price equalization and income convergence. This way, our findings complement Antras-Caballero’s results and refine the condition for the Stolper-Samuelson theorem.