A Pedagogical Note on Risk Sharing Versus Instability in International Financial Integration: When Obstfeld Meets Stiglitz

The pure risk sharing mechanism implies that financial liberalization is growth
enhancing for all countries as the world portfolio shifts from safe low-yield capital to
riskier high-yield capital. This result is typically obtained under the assumption that
the volatilities for risky assets prevailing under autarky are not altered after liberalization. We relax this assumption within a simple two-country model of intertemporal
portfolio choices. By doing so, we put together the risk sharing effect and a well defined instability effect. We identify the conditions under which liberalization may
cause a drop in growth. These conditions combine the typical threshold conditions
outlined in the literature, which concern the deep characteristics of the economies,
and size conditions on the instability effect induced by liberalization.