Leverage Constraints and the International Transmission of Shocks

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 comovement 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 comovement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.

Capital Flow Waves: Surges, Stops, Flight, and Retrenchment

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The International Synchronisation of Business Cycles: the Role of Animal Spirits

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“…2 For example, see Devereux and Sutherland (2008), Devereux and Sutherland (2009), Coeurdacier et al (2010), Devereux and Yetman (2010), Devereux and Sutherland (2010c), Devereux and Sutherland (2010b), Amdur (2010), Coeurdacier and Gourinchas (2011), Viani (2011), Nguyen (2011), Gertler et al (2012, Benigno and Nistico (2012), Berriel and Bhattarai (2013), Berriel (2013), and Karadi et al (2013).…”