In the past three decades the stock of assets and liabilities of developing

countries measured as a ratio of GDP has tripled. It is commonly believed that an

increase in opportunities for diversifying risk allows more consumption smoothing.

However, the data show that volatility of consumption in developing countries

has persisted at high levels, showing only an average 11 percent decrease

from the 60's to the 90's. This paper aims to explain this phenomenon by investigating

to what extent domestic financial frictions related to heterogeneous home

financial market access can help resolve the quantitative discrepancy between

the change in volatility of consumption in the data and that predicted by a model

economy that allows for higher degrees of financial integration. We show that in

an endowment economy, if only 40 percent of the population has access to financial

markets, full access to insuring country risk in international markets would

reduce consumption volatility by 24 percent. In a world in which all agents have

equal access to financial markets, the predicted impact of integration with world

markets would be a much higher drop of 49 percent. The absence of a forward

international market for the nontradable good and the inability of some agents

to access a forward market for the tradable good opens a new role for the spot

market of tradable and nontradable goods: individuals excluded from financial

markets use the goods market to attenuate tradable risk, which is reflected in

higher consumption volatility for these agents following international financial

integration. In an extended version of the model allowing for production, opening

the economy brings even less change in consumption volatility.

Later, we investigate whether limited domestic financial market participation

can break the theoretical result found by Backus and Smith (1993) that consumption

ratios and the real exchange rate are perfectly correlated for pairs of

countries. We consider a two-country world inhabited by individuals with heterogeneous

access to financial markets in one country and full access in the other.

Both countries are endowed with tradable and nontradable goods. We find that

consumption ratios for individuals with access to financial markets are perfectly

correlated with the real exchange rate across countries but the aggregate consumption

ratio and the real exchange rate might not be perfectly correlated across

countries.