Endogenous Inequality of Nations Through Financial Asset Market Integration

The paper analyzes an endogenous mechanism leading perfectly symmetric economies to diverge in the long run after unifying their financial asset markets. The standard OLG growth model is extended to include uncertainty and a financial asset used to transfer ownership of the proceeds of an exogenous random production process between generations. Consumers are risk averse, implying that consumers hold mixed portfolios of real capital and of the asset which are not perfect substitutes. The paper demonstrates that in the absence of an international asset market, the two autarkic economies converge to the same globally attracting steady state under rational expectations dynamics. However, when the two asset markets are unified internationally prior to convergence, additional asymmetric steady states appear implying that the steady state with equal levels of capital becomes unstable, causing symmetry breaking. As a result, depending on the distribution of capital at the time of integration, perfectly symmetric economies in a completely symmetric world can converge to an asymmetric steady state. The paper derives general sufficient conditions for a saddle node bifurcation of the symmetric steady state. These reveal that the instability of the symmetric steady state occurs due to a non linear interaction of the elasticities in production and in asset demand. A numerical example shows that these effects occur in particular, when the production function and the function of absolute risk aversion are isoelastic.