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It is popularly believed that the increase in volatility of financial, goods and labour markets is a natural consequence of greater international capital mobility. The Dornbusch (1976) model of exchange rate suggests that freely operating foreign exchange markets will cause the nominal and real exchange rate to overshoot the long-run equilibrium in response to a monetary shock. The real economy will consequently be destabilised by free capital mobility. It is often argued, however, that such ad hoc models do not take full account of the role of financial markets. Financial markets give economic agents the opportunity to substitute consumption and leisure intertemporally and to share risks. Increased financial market integration may therefore allow agents to deal more effectively with random shocks. The Obstfeld and Rogoff model (1995) incorporates imperfect competition and sluggish price adjustment into an intertemporal optimising framework. It is therefore possible to analyse the interaction between financial integration and goods market imperfections while taking proper account of the role of financial markets in allowing intertemporal substitution. In Discussion Paper No. 1337, Research Fellow Alan Sutherland models imperfect capital mobility in a two-country intertemporal general equilibrium framework by assuming that agents face costs of adjusting asset stocks in foreign asset markets. Goods markets are imperfectly competitive and goods prices are subject to sluggish adjustment. Simulation experiments show that increasing financial market integration (represented by reducing the cost of transacting in foreign asset markets) increases the volatility of a number of variables when shocks originate from the money market, but decreases the volatility of most variables when shocks originate from real demand or supply.
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