Trade Integration, Income Divergence, and Global Imbalances

We embed financial frictions and sector-specific minimum investment requirements (MIR) in a two-factor, two-sector, overlapping-generation model and show that whether trade integration leads to convergence of the income levels among member states depends on their level of financial development. It helps reconcile the mixed empirical evidence on trade integration and income dynamics in different groups of countries from the institutional perspective. In the recent decades, trade globalization has allowed developed countries to specialize towards the high-MIR, high-return production stages and tasks through international fragmentation of production and global sourcing. In our model, the "sectors" can be interpreted broadly as production stages and tasks. Free trade may induce the more financially developed countries to specialize fully in the high-MIR, high-return "sector", which fundamentally changes the credit market condition and the way the interest rate is determined. In this case, free trade may amplify rather than eliminate the global imbalances (a phenomenon of the large capital ows from developing to developed countries observed in the recent years), opposite to the findings of Antras and Caballero (2009, Journal of Political Economy). This way, we argue that trade and financial integration should be analyzed jointly and trade driven structural changes may reshape our understanding of capital fl ows.