| Abstract: |
This paper stresses a new channel through which global financial linkages
contribute to the co-movement in economic activity across countries. We show
in a two-country setting with borrowing constraints that international credit
markets are subject to self-fulfilling variations in the world real interest
rate. Those expectation-driven changes in the borrowing cost in turn act as
global shocks that induce strong cross-country co-movements in both financial
and real variables (such as asset prices, GDP, consumption, investment and
employment). When firms around the world benefit from unexpectedly low debt
repayments today, they borrow and invest more, which leads to excessive supply
of collateral and of loanable funds at a low interest rate, thus fueling a
boom in both home and foreign economies. As a consequence, business cycles are
synchronized internationally. Such a stylized model thus offers one way to
rationalize both the existence of world business-cycle factor documented by
recent empirical studies through dynamic factor analysis and such a factor’s
intimate link to global financial markets. |