Motivation for the Research
Researchers have recently documented significant differences in the structure and function of financial markets across countries. Much of this research explores how such differences can affect the level and growth of economic activity, but little addresses the subject of this paper: how financial markets affect the balance of trade in goods across countries.
The author employs a two-period, exponential-normal, general-equilibrium model with incomplete markets and with countries composed of heterogeneous households. The assumptions of exponential utility and normally distributed endowments and asset payoffs, common in the literature, allow for analytical solutions (but also lead to well-known shortcomings, chief among them being an implication of exponential utility: that absolute tolerance for risk is unaffected by the level or variance of consumption).
The theory discussed in the paper leads to several potentially testable propositions. As mentioned above, researchers have developed measures of financial development, and one could explore the relationship between these measures and trade imbalances. It is worth noting that the United States, with the most sophisticated capital markets in the world, has more-complete markets than any other country. Thus, the fact that the United States also runs large trade deficits is consistent with the theory. On the other hand, the existence of large U.S. trade deficits is inconsistent with the finding that the more national income is spanned by risky assets, the smaller is a country's trade deficit.