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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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  1. Giovanni Lombardo & Luca Dedola, 2010. "Financial Frictions, Financial Integration and the International Propagation of Shocks," 2010 Meeting Papers 288, Society for Economic Dynamics.
  2. Eric Van Wincoop & Cedric Tille, 2007. "International Capital Flows," NBER Working Papers 12856, National Bureau of Economic Research, Inc.
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  6. Cordoba, Juan Carlos & Ripoll, Marla, 2010. "Credit Cycles Redux," Staff General Research Papers 32122, Iowa State University, Department of Economics.
    • 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.
  7. Jean Imbs, 2003. "Trade, Finance, Specialization, and Synchronization," IMF Working Papers 03/81, International Monetary Fund.
  8. Enrique G. Mendoza & Katherine A. Smith, 2004. "Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices," NBER Working Papers 10940, National Bureau of Economic Research, Inc.
  9. Baxter, M. & Jermann, U.J., 1993. "The International Diversification Puzzle is Worse than you Think," RCER Working Papers 350, University of Rochester - Center for Economic Research (RCER).
  10. 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.
  11. Michael B. Devereux & Alan Sutherland, 2008. "Country Portfolios in Open Economy Macro Models," NBER Working Papers 14372, National Bureau of Economic Research, Inc.
  12. 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.
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