Comparative Advantage and International Risk Sharing: Together at Last∗

The overwhelming consensus in the theoretical literature is that access to international risk sharing in the presence of uninsured total factor productivity (TFP) shocks induces a country to specialize more in its comparative advantage industries. This paper demonstrates that the effect of financial integration on production patterns depends on preferences and on the structure of the variance-covariance matrix of TFP shocks present in the economy. Using a variant of the standard 2 × 2 Ricardian model with TFP shocks by Helpman and Razin (1978), I show that if TFP shocks affect each industry in all countries the same way, the standard assumption, then financial integration indeed leads to a more specialized production structure. However, if shocks are not correlated across countries and affect all industries in a country the same way, then the effect of financial integration is ambiguous. I also show that in the absence of international risk sharing the Helpman-Razin model generally has (discrete) multiple equilibria — an overlooked phenomenon. I build a framework with a continuum of goods in the spirit of Eaton-Kortum and show how the multiple equilibria can be numerically bounded. Using this framework I explore the welfare effects of financial integration through its impact on the production structure. This paper can be seen as a first attempt to bring together the discussion of international risk sharing and trade in the context of quantitative trade models of comparative advantage. JEL: F15, F40, F65 ∗I am especially grateful to Jonathan Eaton and Stephen Yeaple for their continued guidance and support. I thank Barry Ickes who’s ideas about the potential welfare benefits from international risk sharing through the feedback on the production structure led to the creation of this paper. The help of Felix Tintelnot on the early stages of this work was invaluable. I thank Michael Fabinger for helping me to formulate the numerical algorithm presented i