International Financial Integration and Crisis Contagion

Michael Devereux and Changhua Yu

The Review of Economic Studies, 2020, vol. 87, issue 3, 1174-1212

Abstract: International financial integration helps to diversify risk but also may spread crises across countries. We provide a quantitative analysis of this trade-off in a two-country general equilibrium model with collateral-constrained borrowing using a global solution method. Borrowing constraints bind occasionally, depending upon the state of the economy and levels of inherited debt. We examine different degrees of international financial integration, moving from financial autarky, to bond and equity market integration. Financial integration leads to a significant increase in global leverage, substantially escalates the probability of crises for any one country, and dramatically increases the degree of "contagion" across countries. Outside of crises, the impact of financial integration on macroeconomic aggregates is relatively small. But the impact of a crisis with integrated international financial markets is much less severe than that under financial market autarky. Thus, a trade-off emerges between the probability of crises and the severity of crises. Using a large cross-country database of financial crises in developing and developed economies over a forty-year period, we find evidence in support of the model.

Keywords: International financial integration; Occasionally binding constraints; Financial contagion; Leverage (search for similar items in EconPapers)
JEL-codes: D52 F36 F44 G11 G15 (search for similar items in EconPapers)
Date: 2020
References: Add references at CitEc
Citations: View citations in EconPapers (28)

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Related works:
Working Paper: International Financial Integration and Crisis Contagion (2014)
Working Paper: International financial integration and crisis contagion (2014)
Working Paper: International Financial Integration and Crisis Contagion (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:oup:restud:v:87:y:2020:i:3:p:1174-1212.

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