Neoclassical Growth in an Interdependent World

We generalize the closed-economy neoclassical growth model (CNGM) to allow for costly goods trade and capital flows with imperfect substitutability between countries. We show that our framework rationalizes the observed gravity equations for trade and capital holdings. We find that goods and capital market integration interact in non-trivial ways. Opening the CNGM to only goods trade or only capital flows increases the speed of convergence to steady-state. In contrast, opening the CNGM to both goods trade and capital flows decreases this speed of convergence. Our framework is well suited for analysing counterfactual policies that affect bilateral integration in both goods and capital markets (e.g., U.S.-China