Leverage Constraints and the International Transmission of Shocks

53 Pages Posted: 2 Aug 2010 Last revised: 4 May 2023

See all articles by Michael B. Devereux

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

James Yetman

Bank for International Settlements (BIS)

Date Written: July 2010

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 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.

Suggested Citation

Devereux, Michael B. and Yetman, James, Leverage Constraints and the International Transmission of Shocks (July 2010). NBER Working Paper No. w16226, Available at SSRN: https://ssrn.com/abstract=1651411

Michael B. Devereux (Contact Author)

University of British Columbia (UBC) - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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James Yetman

Bank for International Settlements (BIS) ( email )

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Basel, Basel-Stadt 4002
Switzerland

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