Working Paper

Leverage constraints and the international transmission of shocks

Abstract: 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 financial institutions. In the absence of leverage constraints, international portfolio diversification has no implications for macroeconomic comovements. When leverage constraints bind, however, the presence of diversified portfolios in combination with these constraints introduces a powerful financial transmission channel, which results in a high correlation among macroeconomic aggregates during business cycle downturns, quite independent of the size of international trade linkages. Conversely, the paper shows that, conditional on leverage constraints binding, international financial integration through equity markets reverses the sign of the international comovement of shocks, leading comovement to switch from negative to positive.

JEL Classification: F3; F32; F34;

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Globalization Institute Working Papers

Publication Date: 2010

Number: 45

Note: Published as: Devereux, Michael B. and James Yetman (2010), "Leverage Constraints and the International Transmission of Shocks," Journal of Money, Credit and Banking 42 (s1): 71-105.