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Abstract

This paper develops a stochastic continuous-time model in which international risk sharing can yield substantial welfare gains through its positive effect on expected consumption growth. The mechanism linking global diversification to growth is an attendant world portfolio shift from safe but low-yield capital into riskier high-yield capital. The presence of these two types of capital is meant to capture the idea that growth depends on the availability of an ever-increasing array of specialized, hence inherently risky, production inputs. Calibration exercises based on international consumption and stock market data imply that most countries reap large steady-state welfare gains from global financial integration.

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