HERE is a new working paper I wrote together with Georg Müller-Fürstenberger, Professor at University of Trier, Germany. In this theory paper we build a two-country model with an international externality. This is the abstract:
We develop an overlapping generations general equilibrium model with two regions. Only one of the regions is subject to an international environmental externality. We find that regions that are too poor to sufficiently offset the international externality imposed upon them may be stuck in a poverty trap. International capital markets eliminate this trap. However, regions that are not in the trap are likely to experience long-run welfare losses when capital markets are integrated compared to the autarky case. This suggests that poor and small regions fare better with integrated capital markets while rich regions, or those regions able to sufficiently impact their environmental quality, should not integrate capital markets for environmental reasons alone.
So basically the storyline is that one player/country/region can harm another player/country/region through a negative externality, and this externality may hinder or even stop the economic development of that player/country/region. For example, take climate change and rising sea levels. Rich countries with large emissions impose the negative externality of climate change upon regions like sub-Saharan Africa, or countries like Bangladesh (through sea level rise). In order to reduce the impact of that externality those regions need to spend large amounts of money that hinder or stop their economic development. However, if capital markets get integrated between both regions, the one affecting and the other being affected, then investors will make use of the interest rate differential, more capital will flow from the rich to the poor region, and thus there’ll be a potential economic takeoff and further development out of the trap. We call that trap the environmental poverty trap.
UPDATE 10 March 2016: We worked over the paper again and you can find the new version HERE.