Leverage Constraints and the International Transmission of Shocks

by Michael B. Devereux and James Yetman


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 co-movements. 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.

Devereux and Yetman extend Krugman’s (2008) partial equilibrium “international financial multiplier” into a full-blown general equlibrium model. When leverage constraints bind, business cycle shocks propagate strongly across countries through inter-connected balance sheets. A fall in asset values in one country leads to asset sales in another country, thus propagating the asset price drop. The asset sales force borrowing reductions (leverage constraints bind), which have negative real effects in all countries. The adverse effects are magnified by the price drop feedback loop. It would be interesting to see how this result evolves in a more complete framework where trade provides alternative means of diversification.

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