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Trade Costs, Asset Market Frictions and Risk Sharing: A Joint Test

Jul 2006
Working Paper
By  Doireann Fitzgerald
This paper addresses the question of whether both goods and asset market frictions are necessary to explain the failure of consumption risk sharing across countries. I develop a test that uses bilateral import data to identify separately the role of trade costs and asset market frictions. I implement this test for a sample of 80 developed and developing countries, 1970-2000, and find that both frictions are necessary to explain the failure of perfect consumption risk sharing. At the same time, financial autarky is also rejected. Asset market frictions are relatively less important for developed than developing countries, and relatively less important in the second half of the sample period compared to the first half. Trade costs are found to be economically important, though declining in magnitude over time. The method I develop also provides estimates of the marginal utility of wealth, which is found to be more volatile in developing than developed countries.