A Neoclassical Model of the World Financial Cycle

RePEc Short ID: pke4
ORCID iD: 0000-0001-5738-1236

Bai, Yan; Kehoe, Patrick J.; Lopez, Pierlauro; Perri, Fabrizio

doi:10.26509/frbc-wp-202506

Working Paper

A Neoclassical Model of the World Financial Cycle

Abstract: Emerging markets face large and persistent fluctuations in sovereign spreads. To what extent are these fluctuations driven by local shocks versus financial conditions in advanced economies? To answer this question, we develop a neoclassical business cycle model of a world economy with an advanced country, the North, and many emerging market economies, the South. Northern households invest in domestic stocks, domestic defaultable bonds, and international sovereign debt. Over the 2008-2016 period, the global cycle phase, the North accounts for 68% of Southern spreads' fluctuations. Over the whole 1994-2024 period, however, Northern shocks account for less than 20% of these fluctuations.

Keywords: international business cycles; sovereign debt; default; long run risk; Epstein-Zin preferences; global banks; global cycles;

JEL Classification: E32; F44; G15; H63;

https://doi.org/10.26509/frbc-wp-202506