International Transmission of Financial Shocks without Financial Integration

This study analyzes how financial shocks in one country transmit to another country through international trade. To this end, it develops a dynamic general equilibrium model of two-country Ricardian trade with a continuum of goods. Financial frictions exist in each country and the two countries can be asymmetric in terms of the degree of frictions, which can be a novel source of comparative advantage. In the case of a permanent credit crunch, we can analytically show that such a shock reduces the long-run investment, GDP, wage income, and aggregate income of heterogeneous entrepreneurs in both countries. We also numerically investigate the transitory responses to a temporal credit shock and show that such an internationally synchronized economic downturn is also observed during transition periods