Financial Integration and International Dynamics: The Role of Volatility Shocks

Abstract

This study investigates the impact of financial integration on international dynamics from the perspective of volatility shocks. By incorporating time-varying volatilities, recursive preferences, and a global bank into the IRBC model, it illustrates that volatility shocks trigger precautionary saving incentives, but the specific effects vary based on the type of shock. Financial integration facilitates international capital flows and leads to an unequal distribution of international bank loans between two countries, resulting in greater divergence in their business cycles in the presence of productivity volatilities. In contrast, countries with higher financial integration experience more synchronized business cycles, due to simultaneous fluctuations in the international financial market, ultimately yielding greater synchronization in the face of financial volatilities. Disregarding volatility shocks leads to underestimating the impact of financial integration on the comovement of business cycles across countries. Furthermore, welfare analysis also indicates that financial markets play a crucial role in enhancing social welfare, regardless of the type of volatility.