THE INSTABILITY OF OPEN PARETO EFFICIENT ECONOMIES

The purpose of this paper is to investigate the impact of the opening to international trade on the local stability properties of trading countries. We consider a two-country two-good two-factor overlapping generations model. We suppose that countries only di ff er with respect to their technology. In the autarky equilibrium and the free-trade equilibrium, we prove the existence of sunspot cycles under dynamic e ffi ciency when the consumption good is capital intensive, the value of the elasticity of intertem- poral substitution in consumption is intermediate and the degree of returns to scale is su ffi ciently high. We show that globalization can be a source of a global destabilizing e ff ect. Indeed, considering a free-trade equilibrium in which one country is an exporter of the consumption good and the other country is an exporter of the investment good, endogenous cycles can occur in the free-trade equilibrium even though the two countries are characterized by saddle-point stability in the autarky equilibrium. We establish that opening to international trade deteriorates the stationary welfare of the country that exports the invest- ment good and improves the stationary welfare of the country that exports the consumption good. Finally, we prove that a fiscal policy can prevent the existence of sunspot fluctuations and welfare losses in the world economy by driving it to the optimal steady state as soon as it is announced .