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Leverage Constraints and the International Transmission of Shocks

  • Michael B. Devereux

    (University of British Columbia and National Bureau of Economic Research and Centre for Economic Policy Research and Hong Kong Institute for Monetary Research)

  • James Yetman

    (Bank for International Settlements and Hong Kong Institute for Monetary Research)

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 co-movements. When leverage constraints bind however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel which results in a positive co-movement 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 co-movement. If international financial markets allow for trade only in non-contingent bonds, but not equities, then the international co-movement of shocks is negative. Thus, with leverage constraints, moving from bond trade to equity trade reverses the sign of the international transmission of shocks.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 132010.

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Length: 43 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:hkm:wpaper:132010
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  1. Michael B. Devereux & Alan Sutherland, 2011. "Country Portfolios In Open Economy Macro‐Models," Journal of the European Economic Association, European Economic Association, vol. 9(2), pages 337-369, 04.
  2. Mendoza, Enrique G. & Smith, Katherine A., 2006. "Quantitative implications of a debt-deflation theory of Sudden Stops and asset prices," Journal of International Economics, Elsevier, vol. 70(1), pages 82-114, September.
  3. 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.
  4. Heathcote, Jonathan & Perri, Fabrizio, 2002. "Financial Globalization and Real Regionalization," CEPR Discussion Papers 3268, C.E.P.R. Discussion Papers.
  5. Heathcote, Jonathan & Perri, Fabrizio, 1999. "Financial Autarky and International Business Cycles," SSE/EFI Working Paper Series in Economics and Finance 320, Stockholm School of Economics, revised 30 Apr 2000.
  6. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  7. Tille, Cédric & van Wincoop, Eric, 2010. "International capital flows," Journal of International Economics, Elsevier, vol. 80(2), pages 157-175, March.
  8. 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.
  9. Baxter, Marianne & Jermann, Urban J, 1997. "The International Diversification Puzzle Is Worse Than You Think," American Economic Review, American Economic Association, vol. 87(1), pages 170-80, March.
  10. Imbs, Jean, 2004. "The Real Effects of Financial Integration," CEPR Discussion Papers 4335, C.E.P.R. Discussion Papers.
  11. repec:bla:restud:v:75:y:2008:i:4:p:1215-1256 is not listed on IDEAS
  12. Matteo Iacoviello, 2002. "House prices, borrowing constraints and monetary policy in the business cycle," Boston College Working Papers in Economics 542, Boston College Department of Economics, revised 06 Dec 2004.
  13. Devereux, Michael B. & Sutherland, Alan, 2010. "Country portfolio dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 34(7), pages 1325-1342, July.
  14. Faia, Ester, 2007. "Finance and international business cycles," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1018-1034, May.
  15. Imbs, Jean, 2003. "Trade, Finance, Specialization and Synchronization," CEPR Discussion Papers 3779, C.E.P.R. Discussion Papers.
  16. Luca Dedola & Giovanni Lombardo, 2012. "Financial frictions, financial integration and the international propagation of shocks," Economic Policy, CEPR;CES;MSH, vol. 27(70), pages 319-359, 04.
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