Working Paper: NBER ID: w16226
Authors: Michael B. Devereux; James Yetman
Abstract: Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage-constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro co-movements. When leverage constraints bind however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel which results in a positive co-movement of production, independently of the size of international trade linkages. In addition, the paper shows that, with binding leverage constraints, the type of financial integration is critical for international co-movement. If international financial markets allow for trade only in non-contingent bonds, but not equities, then the international co-movement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.
Keywords: Leverage Constraints; International Transmission; Financial Integration; Macroeconomic Shocks
JEL Codes: F21; F33; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Leverage constraints bind (D10) | Financial integration leads to positive comovement of production across countries (F30) |
| Absence of leverage constraints (D10) | Financial integration does not lead to international macroeconomic comovements (F30) |
| Negative shock in one country (F65) | Cascade of balance sheet contractions across countries (F65) |
| Cascade of balance sheet contractions across countries (F65) | Positive comovement in production (E23) |
| Fall in asset values (G19) | Forced asset sales and reduction in borrowing globally (F65) |
| Type of financial integration matters (F30) | Transmission of shocks can be negative or positive (E32) |