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International Transmission of Financial Shocks in an Estimated DSGE model

  • Uluc Aysun

    ()

    (University of Central Florida, Orlando, FL)

  • Sami Alpanda

    ()

    (Bank of Canada, Ottawa, Ontario, Canada)

This paper investigates the transmission mechanism of financial shocks across large economies. To quantify these effects, we construct and estimate a two-region open economy DSGE model with nominal and real rigidities. We model the financial side of the economies using the financial accelerator mechanism of Bernanke et al. (1999). We find that the baseline model fails to generate the high degree of macroeconomic correlation between the U.S. and Euro Area economies. Allowing for an ad hoc, cross-regional correlation in financial shocks considerably improves the model’s ability to replicate the spill-over effects of U.S. financial shocks. We then extend the baseline model by including global banking and generate an endogenous, crossregional correlation of cost of capital. Simulations demonstrate a larger Euro Area response to U.S. shocks and highlight the importance of including frictions in international financial contracts, and not only in domestic financial contracts, for more accurately capturing the international transmission of domestic shocks.

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Paper provided by University of Central Florida, Department of Economics in its series Working Papers with number 2012-06.

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Length: 46 Pages
Date of creation: Oct 2012
Date of revision:
Handle: RePEc:cfl:wpaper:2012-06
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