A Theory of the Global Financial Cycle

Abstract

We develop a theory to account for changes in prices of risky and safe assets and gross and net capital flows over the global financial cycle (GFC). The multi-country model features global risk-aversion shocks and heterogeneity of investors both within and across countries. Within-country heterogeneity is needed to account for the drop in gross capital flows during a negative GFC shock (higher global risk-aversion). Cross-country heterogeneity is needed to account for the differential vulnerability of countries to a negative GFC shock. The key vulnerability is associated with leverage. In both the data and the theory, leveraged countries (net borrowers of safe assets) deleverage through negative net outflows of risky assets and positive net outflows of safe assets, experience a rise in the current account and a greater than average drop in risky asset prices. The opposite is the case for non-leveraged countries (net lenders of safe assets).

Uncertainty Shocks, Capital Flows, and International Risk Spillovers

“…Recent work with a related objective is a paper byDavis and van Wincoop (2021) that provides a theoretical framework for the GFC. Unlike our GFC framework, which focuses on the role of uncertainty (or volatility) shocks, the main driver of the GFC in their paper is a shock to the risk aversion parameter.…”