Risk, Nonconvergence and Cycles: A Two-Country Model

We develop an overlapping generations model with asset and capital accumulation to analyze the interaction between the real economy and international asset markets. The world consists of two homogenous countries with an integrated asset market, which differ only in levels of their capital stock. Two period lived consumers transfer wealth over time and across countries by holding international assets with stochastic dividends. Short sale of assets allows poor economy to take credit for productive investment. Yet, risk aversion and expectations may preclude capital stock of both countries from converging while capital flows from the rich to the poor country. The poor country needs sufficiently high capital stock initially to catch up with the rich country. Cycles in capital stocks and international capital flows occur.