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Corsetti, G., Lipinska, A. and Lombardo, G.

Sharing Asymmetric Tail Risk Smoothing, Asset Pricing and Terms of Trade

WP Number: 2123

Abstract: With the Global Financial Crisis, the COVID-19 pandemic, and the looming Climate Change, investors and policymakers around the world are bracing for a new global environment with heightened tail risk. Asymmetric exposure to this risk across countries raises the private and social value of arrangements improving insurance. We offer an analytical decomposition of the welfare effects of efficient capital market integration into a "smoothing" and a "level effect". Enhancing risk sharing affects the volatility of consumption, but also brings about equilibrium adjustment in asset and goods prices. This in turn drives relative wealth and consumption, as well as labor and capital allocation, across borders. Using model simulation, we explore quantitatively the empirical relevance of the different channels through which riskier and safer countries benefit from sharing macroeconomic risk. We offer an algorithm for the correct solution of the equilibrium using DSGE models under complete markets, at higher order of approximation.

Keywords: Asymmetry, Fat Tails, International Risk Sharing, Transfer Problem, Welfare

JEL Codes: F15 F41 G15

Author links: Giancarlo Corsetti  

PDF: wp2123.pdf

Open Access Link: 10.17863/CAM.74488

Keynes Fund Project(s):
Disaster Risk, Asset Prices and the Macroeconomy (JHUX)  

Theme: transmission