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Leverage Constraints and the International Transmission of Shocks

  • MICHAEL B. DEVEREUX
  • JAMES YETMAN

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 comovements. When leverage constraints bind, however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel that 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 comovement. If international financial markets allow for trade only in noncontingent 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. Copyright (c) 2010 The Ohio State University.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 42 (2010)
Issue (Month): s1 (09)
Pages: 71-105

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Handle: RePEc:mcb:jmoncb:v:42:y:2010:i:s1:p:71-105
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