Risk and Capital Accumulation in a Small Open Economy

Abstract

This paper examines the dynamics of capital accumulation in a small open economy where home capital is risky and consumers are risk-averse. It is assumed that the economy participates in perfect international bond markets but that risky home capital is held by domestic residents only. Under these assumptions the rate of investment is no longer independent of the saving rate, and they are positively related. As a result, a rise in savings does not increase foreign investment by the same amount but by less, and in some situations the quantity of foreign assets may even decrease.