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International Business Cycles and Financial Frictions

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  • Wen Yao

Abstract

This paper builds a two-country DSGE model to study the quantitative impact of financial frictions on business cycle co-movements when investors have foreign asset exposure. The investor in each country holds capital in both countries and faces a leverage constraint on her debt. I show quantitatively that financial frictions along with foreign asset exposure give rise to a multiplier effect that amplifies the transmission of shocks between countries. The key mechanism is that a negative shock in the home country reduces the wealth of investors in both countries, which tightens their leverage constraints, leading to a fall in investment, consumption, and hours worked in the foreign country. Compared to the existing literature, which tends to produce either negative or positive but small cross-country correlations, this model produces positive and sizable correlations that are consistent with the data. The model can account for most of the investment, employment and consumption correlations and predicts more than half of the output correlation. In addition, the model shows that, consistent with empirical findings, when investors have more foreign asset exposure to the other country, the output correlation between the two countries increases.

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  • Wen Yao, 2012. "International Business Cycles and Financial Frictions," Staff Working Papers 12-19, Bank of Canada.
  • Handle: RePEc:bca:bocawp:12-19
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    4. Debarsy, Nicolas & Dossougoin, Cyrille & Ertur, Cem & Gnabo, Jean-Yves, 2018. "Measuring sovereign risk spillovers and assessing the role of transmission channels: A spatial econometrics approach," Journal of Economic Dynamics and Control, Elsevier, vol. 87(C), pages 21-45.
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    6. Pierre-Richard Agénor & Timothy P. Jackson & Luiz Pereira da Silva, 2020. "Cross-Border Regulatory Spillovers and Macroprudential Policy Coordination," Working Papers 202028, University of Liverpool, Department of Economics.
    7. Paul De Grauwe & Yuemei Ji, 2016. "Animal Spirits and the International Transmission of Business Cycles," CESifo Working Paper Series 5810, CESifo.
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    9. Maksim Evseevich Krivelevich, 2019. "Export-Oriented Financial Center in the Russian Far East: Abstraction or Reality?," Spatial Economics=Prostranstvennaya Ekonomika, Economic Research Institute, Far Eastern Branch, Russian Academy of Sciences (Khabarovsk, Russia), issue 2, pages 75-91.
    10. Tang, Aidi & Yao, Wen, 2022. "The effects of financial integration during crises," Journal of International Money and Finance, Elsevier, vol. 124(C).
    11. Letendre, Marc-André & Wagner, Joel, 2018. "Agency Costs, Risk Shocks, And International Cycles," Macroeconomic Dynamics, Cambridge University Press, vol. 22(5), pages 1134-1172, July.
    12. De Grauwe, Paul & Ji, Yuemei, 2016. "International correlation of business cycles in a behavioral macroeconomic model," CEPR Discussion Papers 11257, C.E.P.R. Discussion Papers.
    13. Ohdoi, Ryoji, 2020. "Trade, Growth, and the International Transmission of Financial Shocks," MPRA Paper 100756, University Library of Munich, Germany.
    14. Adams, Jonathan J. & Barrett, Philip, 2021. "Why are countries’ asset portfolios exposed to nominal exchange rates?," Journal of International Money and Finance, Elsevier, vol. 110(C).
    15. Been-Lon Chen & Yunfang Hu & Kazuo Mino, 2020. "Capital Allocation and Wealth Distribution in a Global Economy with Financial Frictions," KIER Working Papers 1045, Kyoto University, Institute of Economic Research.
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    More about this item

    Keywords

    Business fluctuations and cycles; International financial markets; International topics;
    All these keywords.

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F44 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Business Cycles

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