Abstract

We generalize the closed-economy neoclassical growth model (CNGM) to allow for open goods and capital markets with imperfect substitutability between countries. We simultaneously model international trade, gross and net capital holdings at a point in time, and intertemporal savings decisions over time, and hence the current account. We show that our framework rationalizes the observed gravity equation relationships for trade and capital holdings in the data. We find a substantially slower speed of convergence to steady state than in the CNGM. Furthermore, goods and capital market integration interact in non-trivial ways. With either free trade or free capital, convergence is faster than in CNGM. In contrast, under both free trade and free capital, convergence is slower than in CNGM. In response to counterfactual changes in bilateral trade frictions, reallocations of capital across countries lead to a substantially different incidence of static and dynamic welfare gains and losses than a world of capital market autarky.