Patience, persistence, and welfare costs of incomplete markets in open economies

We investigate the welfare implications of alternative financial market structures in a two-country endowment economy model. We obtain an analytic expression for the expected lifetime utility of the representative household when sovereign bonds are the only internationally traded asset, and we compare this welfare level with that obtained under complete asset markets. The welfare cost of incomplete markets is negligible if agents are very patient and shocks are not very persistent, but this cost is dramatically larger if agents are relatively impatient and shocks are highly persistent. For realistic cases in which agents are very patient and shocks are highly persistent, the welfare cost of incomplete markets is highly sensitive to the specific values of these parameters.