World Trade During Financial Crises

financial crisis. This paper develops a model of world trade and financial frictions to gain insights into the mechanisms by which a deterioration in financial conditions interact with countries' exports and imports. We extend the international business cycle model to a model of a continuum of countries in an environment with imperfect financial markets. In the model, countries use capital and labor to produce consumption or investment goods. Investment goods require a composite of intermediate goods from all countries in the world. Countries also borrow and lend uncontingent bonds with the rest of the world, but face time varying borrowing constraints that are country specific. The key idea is that countries with large enough debt levels have to reduce consumption and investment when the credit shock hits. As investment declines, both imports and exports decline substantially in these countries. Hence, even countries without large debt holdings have to reduce their exports due to a shrinkage in the demand for imports in the world.