Working Paper: NBER ID: w11550
Authors: Philippe Martin; Hélène Rey
Abstract: This paper develops a theory of financial crisis based on the demand side of the economy. We analyze the impact of financial and trade globalizations on asset prices, investment and the possibility of self-fulfilling financial crashes. In a two-country model, we show that financial and trade globalizations have different effects on asset prices, investment and income in the emerging market and in the industrialized country. Whereas trade globalization always has a positive effect on the emerging market, financial globalization may not, especially when trade costs are high. For intermediate levels of financial transaction costs and high levels of trade costs, pessimistic expectations can be self-fulfilling and may lead to a collapse in demand for goods and assets of the emerging market. Such a crash in asset prices is accompanied by a current account reversal, a drop in income and investment and more market incompleteness. We show that countries with lower income are more prone to such demand-based financial crashes. Our model can replicate the main stylized facts of financial crashes in emerging markets. Our results strongly suggest that emerging markets should liberalize trade in goods before trade in assets.
Keywords: Globalization; Emerging Markets; Financial Crashes; Trade Openness; Capital Flows
JEL Codes: F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trade globalization (F69) | emerging markets (O53) |
| financial globalization (F30) | negative outcomes (I12) |
| high trade costs + intermediate financial transaction costs (F19) | pessimistic expectations (D84) |
| pessimistic expectations (D84) | collapse in demand for goods and assets in emerging markets (F65) |
| collapse in demand for goods and assets in emerging markets (F65) | reduced asset demand (G19) |
| reduced asset demand (G19) | capital flight (F21) |
| capital flight (F21) | crash in asset prices (G01) |
| lower income levels (I32) | vulnerability to financial crises (F65) |
| trade liberalization (F13) | mitigate risks of financial crashes (G01) |