Working Paper: CEPR ID: DP10209
Authors: Michael B. Devereux; Changhua Yu
Abstract: International financial integration helps to diversify risk but also may increase the transmission of crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with endogenous portfolio choice and collateral constraints. Collateral constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. The analysis allows for different degrees of financial integration, moving from financial autarky to bond market integration and equity market integration. Financial integration leads to a significant increase in global leverage, doubles the probability of balance sheet crises for any one country, and dramatically increases the degree of `contagion' across countries. Outside of crises, the impact of financial integration on macro aggregates is relatively small. But the impact of a crisis with integrated international financial markets is much less severe than that under financial market autarky. Thus, a trade-off emerges between the probability of crises and the severity of crises. Financial integration can raise or lower welfare, depending on the scale of macroeconomic risk. In particular, in a low risk environment, the increased leverage resulting from financial integration can reduce welfare of investors.
Keywords: financial contagion; international financial integration; leverage; occasionally binding contracts
JEL Codes: D52; F36; F44; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial integration (F30) | global leverage (F65) |
| global leverage (F65) | balance sheet crises (F65) |
| financial integration (F30) | financial crises (G01) |
| financial crises (G01) | output losses (D57) |
| financial crises (G01) | consumption losses (E21) |
| financial integration (F30) | welfare outcomes (I38) |
| macroeconomic risk (E66) | net effect of financial integration on welfare (F30) |