A Theory of the Global Financial Cycle

Jonathan Davis and Eric van Wincoop

No 29217, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a theory to account for changes in prices of risky and safe assets and gross and net capital flows over the global financial cycle (GFC). The multi-country model features global risk-aversion shocks and heterogeneity of investors both within and across countries. Within-country heterogeneity is needed to account for the drop in gross capital flows during a negative GFC shock (higher global risk-aversion). Cross-country heterogeneity is needed to account for the differential vulnerability of countries to a negative GFC shock. The key vulnerability is associated with leverage. In both the data and the theory, leveraged countries (net borrowers of safe assets) deleverage through negative net outflows of risky assets and positive net outflows of safe assets, experience a rise in the current account and a greater than average drop in risky asset prices. The opposite is the case for non-leveraged countries (net lenders of safe assets).

JEL-codes: F30 F40 (search for similar items in EconPapers)
Date: 2021-09
New Economics Papers: this item is included in nep-cba, nep-cwa, nep-fdg, nep-ifn, nep-isf and nep-opm
Note: IFM
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