International financial integration helps to diversify risk but also may spread crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with collateral-constrained borrowing using a global solution method. Borrowing constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. We examine different degrees of international financial integration, moving from financial autarky, to bond and equity market integration. Financial integration leads to a significant increase in global leverage, substantially escalates the probability of crises for any one country, and dramatically increases the degree of “contagion” across countries. Outside of crises, the impact of financial integration on macroeconomic 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. Using a large cross-country database of financial crises in developing and developed economies over a forty-year period, we find evidence in support of the model.
We thank seminar participants at the Hong Kong Institute for Monetary Research, the UBC macro-lunch, and the Board of Governors of the Federal Reserve Bank for comments. Devereux thanks SSHRC, and the Royal Bank of Canada for financial support as well as support from ESRC award ES/1024174/1. Young thanks the financial support and hospitality of the HKIMR and the Bankard Fund for Political Economy at the University of Virginia. Yu thanks the National Natural Science Foundation of China 71303044, and the financial support and hospitality of the HKIMR. All errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peerreviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.
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