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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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