International asset market, nonconvergence, and endogenous fluctuations

We develop an overlapping generations model with re-tradeable paper assets and capital accumulation to analyze the interaction between the real economy and an international asset market. The world consists of two homogeneous countries, which differ only in their initial levels of capital. Consumers who live for two periods transfer wealth over time and across countries by holding international mutual funds which pay stochastic dividends. The optimal portfolio decisions of consumers do not necessarily induce convergence of incomes between the two countries. Moreover, interaction through the asset market induces endogenous fluctuation of capital flows between the rich and the poor country. © 2007 Elsevier Inc. All rights reserved. JEL classification: E44; F43; O11