Working Paper: CEPR ID: DP10396
Authors: Alberto Martin; Jaume Ventura
Abstract: We live in a new world economy characterized by financial globalization and historically low interest rates. This environment is conducive to countries experiencing credit bubbles that have large macroeconomic effects at home and are quickly propagated abroad. In previous work, we built on the theory of rational bubbles to develop a framework to think about the origins and domestic effects of these credit bubbles. This paper extends that framework to two-country setting and studies the channels through which credit bubbles are transmitted across countries. We find that there are two main channels that work through the interest rate and the terms of trade. The former constitutes a negative spillover, while the latter constitutes a negative spillover in the short run but a positive one in the long run. We study both cooperative and noncooperative policies in this world. The interest-rate and terms-of-trade spillovers produce policy externalities that make the noncooperative outcome suboptimal.
Keywords: asset bubbles; capital controls; exchange rates; financial globalization; interest rates; international capital controls
JEL Codes: E32; E44; O40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low interest rates (E43) | emergence of credit bubbles (F65) |
| emergence of credit bubbles (F65) | credit booms and busts (E32) |
| credit bubbles (E51) | crowding-in effect for credit demand (E51) |
| crowding-in effect for credit demand (E51) | raises world interest rate (E43) |
| credit boom in one country (F65) | capital outflows from others (F32) |
| capital outflows from others (F32) | lowers investment and growth elsewhere (F69) |
| credit boom (F65) | improves terms of trade for booming country (F14) |
| improves terms of trade for booming country (F14) | real appreciation (D46) |
| real appreciation (D46) | worsens terms of trade for the world (F14) |
| supply adjustment (J20) | depreciation (D25) |
| cooperative policies (P13) | stabilize the economy (E63) |
| noncooperative policies (C72) | suboptimal outcomes due to externalities (D62) |