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Leverage Constraints and the International Transmission of Shocks

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  • Michael B. Devereux

    (University of British Columbia and National Bureau of Economic Research and Centre for Economic Policy Research and Hong Kong Institute for Monetary Research)

  • James Yetman

    (Bank for International Settlements and Hong Kong Institute for Monetary Research)

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.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 132010.

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Length: 43 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:hkm:wpaper:132010

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Keywords: Leverage; International Transmission; Portfolios;

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  1. Michael B. Devereux & Alan Sutherland, 2008. "Country portfolios in open economy macro models," Globalization and Monetary Policy Institute Working Paper 09, Federal Reserve Bank of Dallas.
  2. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  3. Cédric Tille & Eric van Wincoop, 2007. "International capital flows," Staff Reports 280, Federal Reserve Bank of New York.
  4. Jonathan Heathcote, 2003. "Financial Globalization and Real Regionalization," Working Papers gueconwpa~03-03-20, Georgetown University, Department of Economics.
  5. Matteo Iacoviello, 2005. "House Prices, Borrowing Constraints, and Monetary Policy in the Business Cycle," American Economic Review, American Economic Association, vol. 95(3), pages 739-764, June.
  6. Devereux, Michael B & Sutherland, Alan, 2007. "Country Portfolio Dynamics," CEPR Discussion Papers 6208, C.E.P.R. Discussion Papers.
  7. Marianne Baxter & Urban J. Jermann, 1995. "The International Diversification Puzzle is Worse Than You Think," NBER Working Papers 5019, National Bureau of Economic Research, Inc.
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  9. Pavlova, Anna & Rigobon, Roberto, 2008. "The Role of Portfolio Constraints in the International Propagation of Shocks," CEPR Discussion Papers 6647, C.E.P.R. Discussion Papers.
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  13. Imbs, Jean, 2004. "The Real Effects of Financial Integration," CEPR Discussion Papers 4335, C.E.P.R. Discussion Papers.
  14. Luca Dedola & Giovanni Lombardo, 2012. "Financial frictions, financial integration and the international propagation of shocks," Economic Policy, CEPR & CES & MSH, vol. 27(70), pages 319-359, 04.
  15. Juan Cordoba & Marla Ripoll, 2002. "Credit Cycles Redux," Macroeconomics 0210004, EconWPA.
    • Juan-Carlos Cordoba & Marla Ripoll, 2004. "Credit Cycles Redux," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(4), pages 1011-1046, November.
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  1. Leverage Constraints and the International Transmission of Shocks
    by Martin Berka in NEP-OPM blog on 2010-05-02 22:03:47
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