Financial frictions, financial integration and the international propagation of shocks

Optimal monetary policy under commitment with a zero bound on nominal interest rates

Luca Dedola and Giovanni Lombardo

Economic Policy, 2012, vol. 27, issue 70, 319-359

Abstract: The recent Great Recession has been particularly remarkable not only for its unprecedented severity, but also for the exceptional degree of global interdependence in financial and real variables. A much-discussed channel of propagation hinges on the international exposure of the balance sheet of highly leveraged players to ‘toxic’ US assets. Yet, existing evidence on the role of exposure is mixed at best. This paper argues that under financial integration, the fact that leveraged investors face the same returns across internationally traded assets, would tend to equalize their borrowing cost across countries. Model simulations show that an unexpected increase in credit spreads in one country generates a similar increase in credit spreads in other financially integrated countries bringing about a global contraction, quite independently of the exposure to foreign assets in the balance sheet of leveraged investors. Our analysis thus suggests some caution in assessing the risks of ‘contagion’ on the exclusive basis of quantitative measures of integration based on cross-border balance sheet exposure.— Luca Dedola and Giovanni Lombardo

Date: 2012
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Persistent link: https://EconPapers.repec.org/RePEc:oup:ecpoli:v:27:y:2012:i:70:p:319-359.

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