Banking Globalization and International Business Cycles
Kozo Ueda
April 30, 2010

Abstract
This paper constructs a two-country DSGE model to study the nature of therecent …nancial crisis that spread immediately throughout the world owing to theglobalization of banking. In the model, …nancial intermediaries (FIs) sign chained
credit contracts at home and abroad, engaging in cross-border lending to entrepreneurs by undertaking cross-border borrowing from investors. The FIs as well as
the entrepreneurs in two countries are credit constrained, so four net worths matter. Our model reveals that under FIs’globalization, adverse shocks that hit one
country a¤ect the other, yielding business cycle synchronization on both the real
and …nancial sides. It also suggests that the FIs’ globalization, net worth shock,and credit constraints are key to understanding the recent …nancial crisis.

Keywords: Financial accelerator; Financial intermediaries; Correlation (quantity)
puzzle; Business cycle synchronization; Globalization; Monetary policy
JEL Classi…cation: E22; E32; E44; E52; F41

Director, Institute for Monetary and Economic Studies, Bank of Japan (E-mail:kouzou.ueda@boj.or.jp). The author would like to thank Kosuke Aoki, Sylvain Leduc, Tomoyuki
Nakajima, Keisuke Otsu, Makoto Saito, Mark Spiegel, seminar participants at FRB San Francisco,
Hitotsubashi University, Kyoto University, and the sta¤ of the Institute for Monetary and Economic
Studies (IMES), the Bank of Japan, for their useful comments. The author particularly thanks
Lawrence Christiano and Simon Gilchrist at the outset of this research. Views expressed in this paper
are those of the author and do not necessarily re‡ect the o¢ cial views of the Bank of Japan.

11Introduction

The recent …nancial crisis demonstrates the importance of a global linkage between the …nancial market, the …nancial system, and the real economy. The deterioration in the U.S.
subprime mortgage market impaired …nancial intermediaries’(FIs’) capital. Combinedwith banking sector globalization, this led to the global malfunctioning of the …nancial
market and the …nancial system, which weakened world demand. Figures 1 and 2 demonstrate those recent global downturns. GDP and investment dropped around 2007 not
only in the United States but also in Japan and the Euro area; in particular, in Icelandand Ireland, we observe volatile changes in GDP and investment. Cross-border lending
to the United States, Japan, Europe, and developing countries declined around 2007,
with Iceland and Ireland experiencing particularly sharp rises and subsequent drops.1
Stock prices dropped in the major stock exchange markets. That further impaired FIs’capital. FIs’ net worth deteriorated in the United States, Japan, the Euro area,2 andcorporate bond spreads jumped in those areas.3 Standard macroeconomic models havenot, however, captured those global linkage via FIs.
In this paper, we construct a dynamic stochastic general equilibrium (DSGE) model
to shed light on the nature of the recent …nancial crisis associated with its international
propagation under banking globalization. In particular, we investigate whether and under which conditions our model yields a global economic downturn, as was observed in
the recent …nancial crisis. First, by constructing the model, we simulate responses of real
and …nancial variables to di¤erent shocks, asking which shock is responsible for the recent
global economic downturn. Second, we ask whether globalization enhances business cycle
synchronization, simulating economic responses under varying degrees of globalization.
Third, we ask whether credit frictions, in particular, the presence of credit-constrainedFIs, enhance business cycle synchronization, comparing our model with one that omits
FIs’ credit constraint. Finally, we draw implications for various policy measures, discussing the e¤ects of monetary, capital injection, and macroprudential policies on the…nancial market and the real economy at home and abroad.
In the model, FIs sign chained credit contracts at home and abroad. Following
Hirakata, Sudo, and Ueda (2009, 2010, HSU), the credit contracts are vertically chained
1

Cross-border lending is de…ned as consolidated claims on borrowers in the country or region concerned. Its data are available from the Consolidated International Banking Statistics released by the
Bank for International Settlements (BIS). Consolidated claims are those on an immediate borrower basis
and those of foreign claims. Claims on an immediate borrower basis identify counterparties according to
the country in which the immediate borrower is located. Foreign claims consist of cross-border claims,
local claims of foreign a¢ liates in foreign currency, and local claims of foreign a¢ liates in local currency.
Because we are interested in banking sector globalization, we use those statistics that report banks’international …nancial claims. Banks are categorized into each country by their nationalities on aconsolidated basis, including their head o¢ ces and all their branches, and netting of inter-o¢ ce accounts.
Those statistics are used to recognize the country-risk exposure of the major individual nationality
banking groups.
Consolidated claims in Europe include cross-border claims among European countries.
2
FIs’net worth is de…ned as ”corporate equities + equity in the noncorporate business sector” heldby the …nancial business sector. They are obtained from the Flow of Funds Accounts for the UnitedStates and Japan, and the Euro Area Integrated Economic and Financial Accounts for the Euro area.
3
Corporate bond spreads are di¤erences between corporate bond rates and government bond rates.

2

between investors and FIs and between FIs and entrepreneurs. The context of the credit
contract is based on the …nancial accelerator model by Bernanke, Gertler, and Gilchrist(1999, BGG). Unlike BGG, FIs are credit-constrained, as are entrepreneurs. In thispaper, the HSU model is extended to a two-country model. Under banking globalization,
FIs undertake cross-border lending to entrepreneurs through cross-border borrowing frominvestors. FIs as well as entrepreneurs in two countries are credit constrained, so four net
worths matter. The global chained credit contracts via credit-constrained FIs produce a
new channel of business cycle synchronization. Consider, for example, an adverse shock,which leads to a decrease in FIs’net worth. Under banking globalization, the FIs supply
funds to entrepreneurs in the two countries; the adverse shock thus decreases the loans inboth countries, and investment and output decrease simultaneously. Such a new channel
does not arise, unless we consider credit-constrained FIs. This common lender e¤ect
has been shown empirically by Kaminsky and Reinhart (2000) and Van Rijckeghem andWeder (2003).
This paper reveals, …rst, that under banking globalization, adverse shocks that hit
one country a¤ect the other, yielding business cycle synchronization on both the real
and …nancial sides. An adverse productivity shock and a tighter monetary policy shockin one country reduce GDP, investment, and asset prices in the other country. For the
productivity shock, however, cross-border lending increases and risk premiums decreasein the foreign country, which is not observed in the recent …nancial crisis. An adverse
shock to FIs’ net worth in one country not only simultaneously reduces GDP, investment, and asset prices in the other, but also reduces cross-border lending and raises risk
premiums. In this respect, the adverse shock to FIs’net worth is key to understanding
the recent …nancial crisis.4
Second, banking globalization enhances business cycle synchronization. For a shock to
FIs’net worth, without banking globalization, no business cycle synchronization occurs; abilateral correlation for GDP is slightly negative. Under banking globalization, businesscycles are synchronized, and as globalization intensi…es the degree of business cycle
synchronization increases signi…cantly. In this respect, FIs’globalization is also key tounderstanding the recent …nancial crisis.
Third, business cycle synchronization is enhanced, compared with a standard BGG
model in which FIs are not credit constrained. The presence of credit-constrained FIs
works to enhance the …nancial accelerator e¤ect, as is pointed out by HSU (2009). Under banking globalization, the common lender e¤ect also contributes to an increase inbusiness cycle synchronization. In the standard BGG model, because FIs are not credit
constrained, a shock to FIs’ net worth has no e¤ect on the economy, and there is nocommon lender e¤ect. In our model, on the other hand, because FIs are credit constrained, an adverse shock to FIs’net worth in one country raises the cost-of-funds in
two countries, dampening GDP and investment. As a result, the e¤ect of globalization
on business cycle synchronization is much greater than that in the standard BGG model.
In this respect, FIs’credit constraint likewise is key to understanding the recent …nancial
4This account is consistent with HSU (2010) and Perri and Quadrini (2010). Perri and Quadrini(2010) point to the importance of the credit shock. Our paper further argues that among the credit
shocks, the shock to the FI sector is important.

3

crisis.
Lastly, our study suggests that under globalization, policy in one country has a
global impact. Accommodative monetary policy and capital injection policy to FIs in
one country are e¤ective in boosting GDP and investment in the other country.
The remainder of this paper is organized as follows. Section 2 gives an overview ofrelated literature and stylized facts. Section 3 presents a two-country sticky price modelin which both FIs and entrepreneurs are credit constrained. Section 4 shows the model’ssimulation results. Section 5 concludes.

2

Related Literature and Stylized Facts

In this section, we provide an overview of related literature and stylized facts on threepoints: (1) business cycle synchronization; (2) macroeconomic e¤ects of FIs; and (3)globalization. First, we check the presence of business cycle synchronization and review
theoretical studies that have sought to explain business cycle synchronization. Second,
we introduce empirical studies on the e¤ect of FIs’ credit conditions, and theoreticalstudies on their implications from a macroeconomic perspective. Third, we examine theevolution of globalization from the viewpoints of trade and …nancial openness.

2.1

Business Cycle Synchronization

In Figures 1 and 2, we showed the evidence of global downturns in the recent …nancial
crisis. In the United States, Japan, and Europe, in particular, in Iceland and Ireland, economic activity such as GDP and investment weakened; cross-border lending contracted;
asset prices dropped; FIs’net worth deteriorated; and corporate bond spreads jumped.
To examine business cycle synchronization for longer periods, we calculate bilateralcorrelations for GDP and investment in the G7 countries. GDP and investment data
are detrended with the Hodrick–Prescott …lter with =1,600. Tables 1 to 3 report theresults. We …nd that correlations are positive in most cases.5 Bilateral correlations for
GDP (investment) between the United States and Japan are 0.23 (0.29) for the sample
of 1970Q1 to 2008Q4. Table 3 reports changes in bilateral correlations for GDP between
three major countries: the United States, Japan, and Germany. The full sample, 1970Q1
to 2008Q4, is divided into four subsamples: the 1970s, 1980s, 1990s, and 2000s. In the
1990s, GDP correlations are negative between the United States and Japan and between
the United States and Germany.6 In the 2000s, GDP correlations are the highest. The
GDP correlation between the United States and Japan is 0.81 in the 2000s, jumping up
from 0.23 for the full sample.
Theoretically, business cycle synchronization has been regarded as a correlation puzzle
or a quantity puzzle since Backus, Kehoe, and Kydland (1992, BKK). BKK constructeda standard international real business cycle model, and pointed out that their model
predicted a negative correlation for output and investment. The reason is that in response5

See Backus, Kehoe, and Kydland (1992, 1994), Frankel and Rose (1998), and Ambler, Cardia, andZimmermann (2004).
6
Heathcote and Perri (2004) point out decreases in bilteral correlations from 1972–1986 to 1986–2000.

4

to a productivity shock it is e¢ cient to increase investment and the labor supply in the
more productive country and reduce them in the less productive one. The bilateralcorrelations for output and investment thus become negative or close to zero.
Motivated by BKK, a number of papers have tackled the correlation puzzle anddemonstrated that frictions in the …nancial markets resolve the puzzle.7 For example,
Faia (2007) extended the …nancial accelerator model by BGG to a two-country model,
and showed that her model predicted positive output correlations.8
Existing DSGE models are, however, still unable to explain the synchronized movements in various variables such as the decrease in cross-border lending and the rise incorporate bond spreads. In most of those models, the deterioration in FIs’ net worth
plays no economic role. Furthermore, Faia (2007) argues that …nancial globalization
weakens business cycle synchronization, although many empirical studies report thatsuch business cycle synchronization is enhanced.9

2.2

Financial Intermediaries

The main contribution of this paper is to construct a two-country DSGE model that
explicitly incorporates credit-constrained FIs. Without FIs’ credit constraint, a deterioration in FIs’ net worth does not have any economic impact. This eliminates animportant spillover channel, which gives rise to what is often called the common lendere¤ect, arising when borrowers in multiple countries have a common lender. In such acase, an adverse shock in one country worsens the credit conditions of FIs, which causes a
withdrawal of funds from another country; it thus explains positive bilateral correlations.
Several empirical studies support the existence of the common lender e¤ect.10
The recent …nancial crisis and ample empirical studies suggest that declines in FIs’
net worth generate a macroeconomic downturn.11 For example, Peek and Rosengren(1997, 2000) identify a loan supply shock that is speci…c to Japanese banks but external
to the U.S. credit market using panel data, and report that the worsening of FIs’credit
7

See BKK (1994), Baxter and Crucini (1995), Heathcote and Perri (2002, 2004), Kehoe and Perri(2002), Iacovielloa and Minetti (2006), Faia (2007), Dedola and Lombardo (2009), Devereux and Yetman(2009), and Perri and Quadrini (2010). Dedola and Lombardo (2009) and Devereux and Yetman (2009)
calculate the optimal portfolio of investors using the second-order approximation. Dedola and Lombardo(2009) yield negative output correlations. As the …nancial friction, they introduce the BGG model as
in Faia (2007), but assume that capital goods in two countries are tradable, unlike in Faia (2007).
Devereux and Yetman (2009) do not report output correlations, but report positive correlations for
asset holdings. As the …nancial friction, they introduce the Kiyotaki and Moore (1997) model. Their
model abstracts from nominal stickiness, and keep total assets and labor …xed. As another reason forthe positive bilateral correlation, Kose and Yi (2006) and Burstein, Kurz, and Tesar (2008) point out
complementarity between products.
8
See also Gertler, Gilchrist, and Natalucci (2007) for the BGG model extended to an small open
economy model.
9
See Kose, Prasad, and Terrones (2003), Morgan, Strahan, and Rime (2004), and Imbs (2004, 2006).
In contrast, Heathcote and Perri (2004) report opposing results from both empirical and theoreticalsides.
10
See Kaminsky and Reinhart (2000), and Van Rijckeghem and Weder (2003).
11
See Peek and Rosengren (1997, 2000), Calomiris and Mason (2003), Anari, Kolari, and Mason(2005), Ashcraft (2005).

5

conditions generates a macroeconomic downturn.
Theoretically, our model is the extension of the …nancial accelerator model of HSU(2009, 2010) to a two-country model. The HSU model is built upon the BGG model. In
contrast to BGG, however, there are two credit-constrained borrowers, FIs and entrepreneurs. Shocks to the FI sector as well as those to the entrepreneurial sector are ampli…edand propagated to the aggregate ‡uctuations, through endogenous developments in the
net worth in the FI sector and the entrepreneurial sector.12

2.3

Globalization

It is often pointed out that increasing globalization was behind the recent crisis, which
enhanced business cycle synchronization. Accordingly, we examine whether there wasan increase in globalization before the onset of the …nancial crisis. The literature on the
wave of globalization both in goods and …nancial markets is voluminous.13
Figure 3 illustrates globalization in the goods market. As a proxy for trade openness,
the …gure demonstrates the movements of (exports + imports)/2 as a share of GDP for
the United States, Japan, Germany, and the Euro area from 1970. In the United States,
we observe a steady increase in trade openness. In Japan, Germany, and the Euro area,
we observe an accelerated increase in trade openness from the middle of the 1990s.14
Figures 4 to 6 illustrate globalization in the …nancial market. Using BIS’s Consolidated International Banking Statistics, we report cross-border lending in the form ofconsolidated claims on borrowers in the United States, Japan, Europe, and developing
countries from 1999 to 2009 in Figure 4. The top panel indicates the level of consolidated
claims; the middle panel indicates the ratio of consolidated claims to nominal GDP at
the end of the calendar year; and the bottom panel indicates the ratio of consolidated
claims to non-…nancial …rms’ total liabilities. We …nd that consolidated claims, bothin their level and in their ratios, increased over the sample periods, outstandingly inEurope. It suggests increasing risk exposures in the countries examined. For the UnitedStates in 2009, the ratio of consolidated claims to nominal GDP (non-…nancial …rms’
total liabilities) reaches 40 (15) percent. Figure 5 decomposes consolidated claims on the
non-bank private sector and banks.15 Again, we observe increases in consolidated claims,
12

The HSU model is constructed with reference to two lines of literature. The …rst strand focuseson the credit friction associated with the entrepreneurs (BGG; Kiyotaki and Moore [1997], Christiano,
Motto, and Rostagno [2004]). The second strand considers the credit friction of the FIs (Bernanke
and Blinder [1988], Goodfriend and McCallum [2007], Van den Heuvel [2008], Gerali, Neri, Sessa, andSignoretti [2008], Dib [2009], Curdia and Woodford [2009], Gertler and Karadi [2009], Gertler andKiyotaki [2010]). In considering the two types of frictions above, our model is close to the model byChen (2001), Aikman and Paustian (2006), and Meh and Moran (2004), who use quantitative extensionsof the model of Holmstrom and Tirole (1997).
13
See, for example, Crafts (2000), Eichengreen (2001), Bordo, Taylor, and Williamson (2003), Edison,
Klein, Ricci, and Slok (2004), Obstfeld and Taylor (2004), Kose, Prasad, Rogo¤, and Wei (2006), andGoldberg (2009).
14
As for longer records of trade openness, see Findlay and O’Rourke (2003) and originally Maddison(1995, 2001).
15
The …gures report not foreign claims but international claims. International claims equal foreign
claims minus local claims of foreign a¢ liates in local currency.

6both on the non-bank private sector and banks.16 Figure 6 demonstrates the movementsof the ratio of cross-border fund-raising to total fund-raising using the Flow of Funds
Accounts compiled by the Bank of Japan. The statistics report a reference table, Channels of Fund-Raising by the Non…nancial Sector. The cross-border fund-raising is thesum of fund-raising by the domestic non…nancial sector via overseas markets and by theoverseas sector. The ratio of cross-border fund-raising increases from 1979. In 2008, inparticular, the ratio of cross-border fund-raising reached 23 percent largely re‡ecting theincrease in fund-raising by the overseas sector.17

3

Model

We consider a two-country economy with credit and goods markets. Two countries areof equal size. The economy in each country consists of 10 types of agents: a household,investors, FIs, entrepreneurs, capital goods producers, …nal goods producers, retail goods
producers, wholesale goods producers, the monetary authority, and the government.
In this section, we brie‡y describe the main properties of the model. See Appendix
A and B for details.

3.1

Credit Market

Our setting for the credit market is taken from HSU (2009, 2010). As shown in Figure 7,
investors, FIs, and entrepreneurs make chained credit contracts. FIs own their net worth,but not su¢ ciently to …nance the loans to the entrepreneurs. Consequently, FIs makecredit contracts with investors to borrow the rest of the funds (hereafter IF contracts).
Entrepreneurs are the ultimate borrowers of the funds. They also own their net worth,but not su¢ ciently to …nance their projects. Hence, the entrepreneurs engage in thecredit contract with the FIs, to …nance the rest of the funds (hereafter FE contracts).
There are two sources of informational asymmetry in the IF contract and in the FE
contract. This makes both FIs and entrepreneurs credit constrained. The model ofcredit frictions is based on the costly state veri…cation model developed by BGG. In thetwo-country model, the chained credit contracts are depicted as Figure 8. Under banking
globalization, FIs undertake cross-border lending to entrepreneurs through cross-borderborrowing from investors. Because many notations are used, this …gure summarizes
variables and parameters in the credit markets. The left (right) panel represents thehome (foreign) country. Superscripts F and E denote FIs and entrepreneurs, respectively.
Subscripts H and F denote the country of the FIs with credit connections. The asterisk( ) indicates a variable in the foreign country.
16

Those upward trends are con…rmed in longer-term data using the BIS Locational International
Banking Statistics. They report international …nancial claims of banks resident in a given country.
17
While the Flow of Funds Accounts show a clear increase in …nancial openness in Japan, the previous
BIS statistics do not. Such a di¤erence can be explained, because the overseas non-…nancial sector in
the Flow of Funds Accounts corresponds to the non-…nancial sector outside Japan. If that sector isresident in the United States, in the BIS statistics, it is not classi…ed as in Japan but as in the UnitedStates.

7

In the FE contract, each type-i FI in the home country monopolistically o¤ers a loan
contract to group-ji entrepreneurs in the home and foreign countries. Each entrepreneurin group ji in the home country owns net worth N E (st ) : It uses 1 E
H of the net worth totttpurchase capital of (1 E
)Q
(s
)
K
(s
),
where
Q
(s
)
is
the
price
paid
to capital in unitsHHEtof the household consumption index; (1 H )KH (s ) is the quantity of capital purchasedby a group-ji entrepreneur; and st is state of the economy in period t. The type-i
FI thus invests in the loans to group-ji entrepreneurs in the home country an amount
t
t
E
t
(1 E
H )(Q (s ) KH (s ) N (s )): Similarly, the type-i FI invests in the loans to group-jittE
entrepreneurs in the foreign country an amount E(st )): Following
F (Q (s ) KH (s ) N
BGG, we assume that entrepreneurs are subject to an idiosyncratic productivity shockand the FE contract has the costly state veri…cation structure. The FE contract speci…es
a cut-o¤ value of idiosyncratic shock such that entrepreneurs repay their debt if theiridiosyncratic productivity shock is greater than the cut-o¤ value and they declare thedefault otherwise. If the default is declared, FIs pay a monitoring costs to observe
entrepreneurial realized returns, and the default entrepreneurs receive nothing.
In the IF contract, investors lend the loans to a continuum number of FIs. Each
type-i FI in the home country owns the net worth N F (st ) : The type-i FI then borrowsF
the rest from investors in the home country by a portion of 1
H and investors in theFforeign country by a portion of H . The type-i FI is subject to idiosyncratic productivity
shock. The IF contract has the same costly state veri…cation structure as does the FE
contract, whereas FIs now need to act as the borrowers rather than lenders.
E
The four parameters FH ; FF ; E
H ; and F represent exogeneous degrees of banking
globalization or …nancial openness, which determines the allocation of …nance between
the home country and the foreign country. Put di¤erently, FH and FF capture thedegree of banking globalization from FIs’borrowing side, or the …nancial openness of theEinterbank market, and E
H and F capture the degree of banking globalization from FIs’lending side or the …nancial openness of foreign direct investment.
For a given risk-free rate of rerurn R (st ) in the home country, the external …nanceE(st+1 )g=R (st ) is simpli…ed as18
premium Et fRH
E
Et RH(st+1 )=F
R (st )N F (st )N E (st )N F (st )N E (st );;;Q (st ) KH (st ) Q (st ) KH (st ) Q (st ) KH (st ) Q (st ) KH (st )

:

(1)
E
Et fRH(st+1 )g is called cost-of-funds. The cost-of-funds plays an important role in investment. Higher cost-of-funds lowers the price of capital Q, and discourages investment. In
BGG, the external …nance premium is decreasing in the entrepreneurial net worth ratio.
In HSU, FIs as well as entrepreneurs are credit constrained, and the external …nancepremium is decreasing in both FIs’and entrepreneurial net worth ratios. In our model,
the external …nance premium depends on four net worth ratios: FIs’and entrepreneurial
net worth ratios in the two countries. We investigate numerically how each net wortha¤ects the external …nance premium in the next section. Under banking globalization( > 0); the external …nance premium is decreasing in the four net worth ratios.
18

To be more precise, the external …nance premium depends on other variables such as the realexchange rate and the risk-free rate in the foreign country.

8

The net worths of FIs and entrepreneurs depend on their earnings from the credit
contracts and their labor income. Following Gilchrist and Leahy (2002), we consider
net worth shocks de…ned as once-and-for-all changes in the FI’s and entrepreneurial net
worths.

3.2

Goods Market

For the setup of the goods market, we follow the two-country model of BKK (1992, 1994),
and its sticky price extension by Clarida, Gali, and Gertler (2002) and Faia (2007). Finalgoods produced in two countries are di¤erent and tradable; labor and physical capitalare immobile; bond markets, implicit in the model, are complete. Consumption goods ineach country are produced by the …nal goods producers using the Dixit-Stiglitz aggregator of di¤erentiated retail goods. These retail goods are produced by the monopolistic
producers who set Calvo-type sticky prices, using the wholesale goods. The wholesale
goods are produced by the competitive …rms converting capital and labor inputs. Capital
goods are supplied by entrepreneurs, and labor inputs are supplied by household, FIs,and entrepreneurs.
A representative household in the home country consumes C (st ), which is given by
C st = (1

1=
CH
H)

st

(

1)=

+

1=
H CF

st

(

1)=

=(

1)

;

(2)

where CH (st ) and CF (st ) denote the consumption of home-produced goods spent in thehome country and the consumption of foreign-produced goods spent in the home country,
respectively.
Trade openness is captured by H : The parameter H represents the weight on foreignproduced goods. Similarly, we de…ne the weight on home-produced goods in the foreigncountry as F . Those parameters indicate the inverse degree of a home bias.

4

Simulation

4.1

Calibration

We follow HSU and originally BGG for parameter values. The parameter values are
symmetric in two countries. See Appendix C for details.
Regarding the parameters of the two-country model, six parameters capture economic
openness. First, we set = H = F = 0:15 in the benchmark. H and F represent
trade openness in the home and foreign countries. As de…ned in equation (2), the parameter H represents the weight on foreign produced goods. If it is zero, there is no
demand for the foreign goods; this implies no trade of goods. If it is 0.5, there is no homebias. A household in the home country demands equally for the home-produced goods
and foreign-produced goods, provided that their prices are the same. Following Faia
(2007), we set them at 0.15 in the benchmark. That value is consistent with the data
for the United States and Japan. As Figure 3 shows, trade in those countries accounts
for 15 percent of total GDP. A trade share for Europe is higher, reaching more than 30
percent. That partly re‡ects active cross-border trade among European countries.
9E
Second, we set F = FH = FF = 0 and E = E
H = F = 0 in the benchmark forthe parameters of banking globalization or …nancial openness. It is di¢ cult to measure
the actual degree of banking globalization that matches our model, but Figures 4 to 6
provide some clues. The bottom panel of Figure 4 indicates the ratio of foreign claims to
non-…nancial …rms’total liabilities; the latter corresponds to entrepreneurial total assets,
QK; in our model. If foreign claims are all debts and two countries are symmetrical,
foreign claims correspond to E (QK N E )+ F (QK N E N F ) in our model. Therefore,
the ratio of foreign claims to non-…nancial …rms’total liabilities equal
E(1 N E =QK) += 0:5 E + 0:4 F :F(1N E =QKN F =QK)

According to Figure 4, the latest ratios are about 15 percent for the United States, 10
percent for Japan, and 35 percent for the Euro area. Because actual foreign claims are
not all debts, those ratios give the upper limit of E and F : Distribution between E
and F is illustrated by Figure 5, which decomposes foreign claims to those on the nonbank private sector and on banks. For the United States, foreign claims on the non-bankprivate sector are twice as large as those on banks. It suggests E > F : On the contrary,for Japan and Europe, foreign claims on the non-bank private sector is lower than thoseon banks. It suggests E < F : Finally, Japan’s E is demonstrated in Figure 4 as
fund-raising by the domestic non-…nancial sector via overseas markets; it is 3.5 percent
in 2008.

4.2

Net Worth and Cost-of-Funds

E
To examine the property of the credit market, we analyze cost-of-funds Et RH(st+1 )
for entrepreneurs in the home and the foreign country. To begin with, we focus on thepartial equilibrium only of the credit market.19
For varying FIs’ and entrepreneurial net worth ratios in the foreign country, we
calculate how cost-of-funds moves. In Figure 9, the top (bottom) two panels indicate
changes in the premiums to FIs’(entrepreneurial) net worth ratios in the foreign country.
Net worth ratios, N F =Q K or N E =Q K , deviate from the steady state by 0:05 to
0.05. The two left (right) panels indicate changes in the cost-of-funds in the home(foreign) country.
Without banking globalization, the e¤ect of net worth on cost-of-funds is limited
to the country concerned. In Figure 9, black lines with a plus symbol indicate thecase without banking globalization ( = F = E = 0). Both FIs and entrepreneurs
19
In the general equilibrium, equation (26) makes entrepreneurial returns to capital in the homeEcountry obtained by …nancing funds from FIs in the home country RH(st ) equal those obtained by…nancing funds from FIs in the foreign country RFE (st ) : In the partial equilibrium, because equation(26) does not bind, the two returns di¤er. We de…ne the average entrepreneurial cost-of-funds in thehome country by
E
E
t+1 t
E
t+1 t
js + Ejs ;RE st+1 jst(1H )RH sH RF sand analyze changes in RE st+1 jst : Similarly, we analyze RE
of-funds in the foreign country.

10

st+1 jst ; average entrepreneurial cost-borrow funds from agents in their resident country. Lines in the two left panels are ‡at,suggesting that without banking globalization the cost-of-funds in the home country is
independent of net worth in the foreign country. The two right panels suggest that as net
worth in the foreign country decreases, the cost-of-funds in the foreign country increases.
The increase in the cost-of-funds is steeper in response to a change in FIs’ net worth
than to a change in entrepreneurial net worth. This is consistent with HSU. This arises
from the fact that FIs’net worth is smaller than entrepreneurial net worth in the UnitedStates.
Those results do not change when the interbank (FIs’borrowing) markets are open.
Blue lines with circles indicate the case in which FIs borrow half of their funds from theother country ( F = 0:5). The lines are identical to the black lines with a plus symbol.
In the partial equilibrium, because the risk-free rates in the two countries are the sameand the real exchange rate does not change, FIs are indi¤erent between borrowing funds
from the home country and borrowing funds from the foreign country.
When FIs’ lending markets are open, a change in net worth in the home countrya¤ects cost-of-funds in the foreign country, and mitigates a change in cost-of-funds inthe home country. Red lines with dots indicate the case in which entrepreneurs borrow
half of their funds from the other country ( E = 0:5). As FIs’net worth in the foreigncountry decreases, cost-of-funds in the home country increases, as the top-left panel
demonstrates. Entrepreneurs in the foreign country borrow a portion of funds from theFIs in the home country, and their …nancial conditions are constant. That mitigates
an increase in cost-of-funds in the foreign country, as the top-right panel demonstrates.
Entrepreneurial net worth also in‡uences cost-of-funds in the other country. This is
illustrated by the bottom-left panel. From investors’viewpoint in the home country, theworsening of the entrepreneurial net worth in the foreign country enhances the agency
cost problem. This increases the cost-of-funds in the home country. On the other hand,from investors’ viewpoint in the foreign country, the entrepreneurial net worth in thehome country stays constant. This mitigates a change in the cost-of-funds in the foreigncountry.

4.3

Impulse Responses

The previous cost-of-funds curves are drawn using a partial equilibrium framework. Somekey variables are kept …xed. Model dynamics are neglected, such as developments in net
worth and the price of capital.
In the following exercises, we compute the equilibrium response of the economy toshocks in a general equilibrium framework. We study four types of adverse shocks: (i)a productivity shock; (ii) a monetary policy shock; (iii) a net worth shock in the FI
sector; and (iv) a net worth shock in the entrepreneurial sector. The last two shocks,(iii) and (iv), are the sectoral shocks that hit each of the participants in the credit market.
For those shocks, we introduce an innovation either in equation (15) or (16) ; following
Gilchrist and Leahy (2002).
Our particular focus is on bilateral correlations for macroeconomic variables, namely,
GDP and investment. In the following …gures, we show responses of GDP and investment
to shocks, and examine whether a shock in one country yields a similar response of GDP
11and investment in the other country. To analyze the …nancial accelerator channel, we
also present responses of net worth ratios in two countries. The net worth ratios are theratio of the sum of FIs’and entrepreneurial net worth (N = N F + N E ) to total assets(QK). The left (right) panels demonstrate the economic variables in the home (foreign)country. Finally, the real exchange rate is demonstrated in the bottom-left panel.
For comparison with our chained credit contract model (hereafter, CCC model), we
also simulate a “BGG model.”In the BGG model, entrepreneurs are credit-constrained,
but FIs are not. The FI sector is dropped from the CCC model, and the investors andentrepreneurs make direct credit contracts in the same manner as in the BGG model.
Because there is no agency problem associated with the FIs, the FIs’ net worth plays
no role. Thus, the external …nance premium re‡ects only the entrepreneurial net worth.
Consequently, the …nancial accelerator e¤ect of the BGG model comes only from theentrepreneurial sector.20
4.3.1

Benchmark (No Banking Globalization)

As our benchmark, we simulate economic responses of GDP, investment, net worth ratios,
and the real exchange rate in the economy of = 0:15 and = F = E = 0: FIs do not
engage in either cross-border lending or borrowing.
Productivity shock Figure 10 illustrates economic responses to a negative productivity shock in the home country. We consider the productivity shock that decreases
the productivity of wholesale goods-producing sector by one percent at the impact, andreturns to the steady-state level with the autoregressive parameter of 0.85.
We …nd business cycle synchronization with respect to GDP and investment. As theleft panels shows, in the home country GDP and investment decrease. Because productivity decreases, real marginal costs increase, and in‡ation rates rise. That raises nominalinterest rates and lowers the real exchange rate, indicating home currency appreciation.
In the foreign country, we observe a fall in GDP and investment. GDP and investment
exhibit positive bilateral correlations in the two countries. This …nding is consistent
with Faia (2007). As she explains, the credit market friction as well as nominal stickiness plays a key role. The adverse productivity shock raises the real marginal costs
and increases in‡ation rates in the home country. Demand shifts from home-produced
goods to foreign-produced goods raises in‡ation rates in the foreign country. In response,
foreign monetary policy is tightened, deteriorating net worth. That raises cost-of-funds,
which in turn decreases GDP and investment in the foreign country.
Compared with the BGG model, our CCC model reports greater responses of GDP
and investment in the foreign country. The total impacts of two countries are greaterin the CCC model than those in the BGG model, also. That result is consistent with20

We set parameter values related to the entrepreneurial sector in our BGG model to the same values
used in our baseline model. Thus, we set the values of E ; E ; and nE the same across the two models.
Furthermore, we choose the same steady-state return to capital RE for the two models. We choose to
do so because we aim to compare the models’dynamics in a similar economic environment with respect
to aggregate investment. Our choice yields the recalibrated values of E and R for the BGG model,
which di¤er from the baseline model.

12

HSU (2009), which points out that the CCC model enhances the …nancial acceleratore¤ect. In the home country, the responses of GDP and investment are almost equal.
This is because the economy’s response to nominal interest rates is larger in the CCC
model than in the BGG model, but the economy’s response to the productivity shock isalmost the same in the two models. Since GDP and investment in the foreign country
drop more, bilateral correlations of those variables become larger in the CCC model thanthose in the BGG model.
Monetary policy shock Figure 11 illustrates economic responses to the tightening
monetary policy shock in the home country. We consider a case where the nominalinterest rate rises unexpectedly by 0.25 percent (one percent annually) at the impact.
We again …nd business cycle synchronization with respect to GDP and investment.
A rise in the nominal interest rate in the home country increases the real interest rate,causing investors’ opportunity cost to rise. Net worth worsens, and investment falls.
Due to a rise in the nominal interest rate, the real exchange rate drops, implying homecurrency appreciation. In the foreign country, GDP and investment decrease due totwo channels. First, a decrease in demand caused by the increase in the real interest
rate lowers demand for foreign-produced goods as well as home-produced goods. In theforeign country, this lowers returns to capital, deteriorating net worth and dampening
GDP and investment. Second, because the home currency appreciates, there occurs ashift of demand from home-produced goods to foreign-produced goods. In the foreigncountry, it increases in‡ation rates, inducing monetary tightening. Net worth worsens,
and GDP and investment decrease.
Compared with the BGG model, our CCC model reports greater responses of GDP
and investment in the two countries. The CCC model enhances the …nancial acceleratore¤ect due to the presence of credit-constrained FIs.
FIs’net worth shock Figure 12 illustrates economic responses to a negative shock of
FIs’net worth in the home country. We consider a case in which FIs’net worth declines
by one percent of the steady-state GDP. Although the shock to the net worth is a onetime shock and therefore has no inertia, its impacts on the economy are persistent. Thatis, as the demand for capital goods is weakened, the capital price falls, leading to a further
decrease in the investment owing to the endogenous declines in the entrepreneurial net
worth as well as the FIs’net worth.
GDP and investment are not synchronized. Responding to the decline in FIs’ net
worth in the home country, cost-of-funds increases, and GDP and investment decrease.
De‡ation occurs, which lowers nominal interest rates. The real exchange rate increases,
indicating home currency depreciation. In the foreign country, GDP and investment
increase, because the home country experiences de‡ation; it shifts demand for goods
from foreign-produced goods to home-produced goods. In the foreign country, in‡ation
rates drop, and monetary policy is accommodated. Net worth is improved, and cost-ofcapital declines, increasing GDP and investment in the foreign country. As we will show
soon, however, GDP and investment come to have positive bilateral correlations underbanking globalization.
13

In the BGG model, the FIs’net worth shock has no e¤ect on the economy. Because
FIs are not credit constrained, their net worth plays no role.
Entrepreneurial net worth shock Figure 13 illustrates economic responses to anegative shock of entrepreneurial net worth in the home country. We consider a case inwhich entrepreneurial net worth declines by one percent of the steady-state GDP.
We …nd …rst that GDP and investment are not synchronized. The shock to entrepreneurial net worth yields opposing responses of GDP and investment in the two countries.
Second, compared with Figure 12, for the decline in net worth of the same size, the entrepreneurial net worth shock has smaller impacts on GDP and investment than FIs’net
worth shock. This result is in line with HSU and Figure 9. Third, compared with the
BGG model, our CCC model reports greater responses of GDP and investment in thetwo countries.
4.3.2

E¤ects of Banking Globalization

Next, we consider an economy under banking globalization. FIs engage in both crossborder lending and borrowing. The degree of banking globalization is characterized by= F = E = 0:1: We simulate impulse responses of economic variables in response to
the four types of adverse shocks.
Productivity shock Figure 14 plots GDP, investment, the sum of FIs’and entrepreneurial net worth ratios in the two countries, and the real exchange rate. In addition,
Figure 15 plots the FIs’net worth ratios, the entrepreneurial net worth ratios, the external …nance premiums, the price of capital (asset prices), and cross-border lending in
the two countries.21 Figures 14 and 15 illustrate that banking globalization, captured
by positive , yields a larger spillover of the productivity shock in one country to theother country. The two countries experience declines in GDP, investment, FIs’net worth
ratios, and asset prices.
Two channels arise from banking globalization. The …rst is through the exchange rate.
In the home country, the real interest rate increases. The real exchange rate decreases,
meaning home appreciation and foreign depreciation. For FIs in the foreign country, itbinds the participation constraint of investors in the home country more severely. The
net worth ratio worsens and the cost-of-funds increases in the foreign country. GDP andinvestment are thus dampened. Second, through a decrease in returns to capital, theadverse shock in the home country damages the credit conditions of FIs in the homecountry. Because those FIs lend funds to entrepreneurs in the foreign country, the costof-funds increases for the entrepreneurs in the foreign country. It dampens GDP andinvestment in the foreign country.
The second channel above is compared to the so-called common lender e¤ect. Thise¤ect arises when borrowers in multiple countries have a common lender. Suppose,for example, that an adverse shock hits in one country. Then, the FI, the lender toborrowers in the country, withdraws funds from another country; loans thus shrink in
21

Cross-border lending is in the unit of …nal consumption goods in the FIs’country.

14multiple countries. Our model successfully captures this common lender e¤ect. When E
is non-zero, entrepreneurs in the two countries have a common lender. The adverse shockin one country aggravates FIs’net worth, raising cost-of-funds for foreign borrowers. The
common lender e¤ect is absent in the BGG model because FIs are not credit constrained.
The BGG model, therefore, yields a smaller spillover of the shock to the foreign country.
The result that banking globalization enhances business cycle synchronization is consistent with empirical studies (Kose, Prasad, and Terrones [2003], Morgan, Strahan, andRime [2004], and Imbs [2004, 2006]).
The model’s prediction of simultaneous drops in …nancial and real variables is consistent with the recent …nancial crisis shown in Figures 1 and 2. However, a decrease inan external …nance premium in the foreign country and increases in cross-border lending
except for loans from foreign FIs to home entrepreneurs appear to be inconsistent withthose …gures.
Monetary policy shock As Figures 16 and 17 illustrate, for the monetary policy
shock, we obtain similar results to those for the productivity shock. First, the spillovere¤ect increases due to the banking globalization. GDP and investment in the foreigncountry decline more. Second, our CCC model reports a larger spillover e¤ect than the
BGG model.
FIs’net worth shock Figures 18 and 19 illustrate that due to banking globalization,
the FIs’ net worth shock yields completely opposite movements of economic variablesin the foreign economy, compared with those without banking globalization. Withoutbanking globalization, the worsening of credit conditions of FIs in the home country
increases GDP and investment in the foreign country. Under banking globalization, thecommon lender e¤ect arises; the worsening of credit conditions of FIs in the home country
increases the cost-of-funds for entrepreneurs in the foreign country. It dampens GDP andinvestment in the foreign country as well as in the home country. In response to adverse
FIs’net worth shock, the two countries experience simultaneous economic downturns.
Compared with the responses to the productivity shock, the responses to the FIs’
net worth shock are more consistent with our observations on the recent …nancial crisis
that are shown in Figures 1 and 2. The adverse FIs’ net worth shock dampens GDP,
investment, FIs’net worth ratios, and asset prices in the two countries. It also dampens cross-border lending except for loans from foreign FIs to home entrepreneurs, andincreases the external …nance premium in the two countries.
Entrepreneurial net worth shock Also for the entrepreneurial net worth shock, we…nd very di¤erent movements of economic variables in the foreign economy between thecases with and without banking globalization. Figures 20 and 21 suggest that on impact
the worsening of entrepreneurial net worth in the home country decreases investment
in both of the countries. Due to the worsening of entrepreneurial net worth in thehome country, entrepreneurs’ defaults increase. FIs both in the home and the foreigncountry thus pay higher monitoring costs, reducing their pro…ts, and the FIs’net worths

15decrease in the two countries. It raises cost-of-funds for entrepreneurs in the foreigncountry. Investment thus falls in the foreign country.
However, because the worsening in FIs’net worth is not so large, declines in GDP
and investment in the foreign country are not as great as those in response to the same
size of shock to FIs’net worth. While investment falls on impact in the foreign country,
its fall is not persistent and GDP increases on impact in the foreign country. As a result,bilateral correlations for GDP and investment become negative.

4.4

Bilateral Correlations

Tables 4 and 5 report bilateral correlations for macroeconomic variables (GDP and investment, respectively) between the two countries. As before, we consider the four kindsof adverse shocks: (1) a productivity shock; (2) a monetary policy shock; (3) a net worth
shock in the FI sector; and (4) a net worth shock in the entrepreneurial sector. In eachcase, adverse shocks occur in both of the countries. A bilateral correlation for the shocks
is zero, but as we will see below, our model predicts positive bilateral correlations for
GDP and investment.22 For comparison, the tables report bilateral correlations predictedby the BGG model in parentheses.
In the benchmark, predicted bilateral correlations are positive for aggregate shocks.
In response to the productivity shock, a bilateral correlation for GDP is 0.28 and abilateral correlation for investment is 0.53. In response to the monetary policy shock, abilateral correlation for GDP is 0.14 and a bilateral correlation for investment is 0.27.
Those bilateral correlations are greater than those in the BGG model, except for theinvestment correlation in response to the monetary policy shock. For the other shocks,
bilateral correlations are almost zero. For example, for FIs’net worth shock, a negative
bilateral correlation for GDP is -0.11.
Under banking globalization, predicted bilateral correlations become greater thanthose without banking globalization in many cases. For the productivity shock, GDPbilateral correlations increase from 0.28 to 0.41. For the monetary policy shock, GDPbilateral correlations increase from 0.14 to 0.44. For FIs’net worth shock, GDP bilateralcorrelations increase from -0.11 to 0.30. Those increases are sharper in the CCC model
than in the BGG model. Although investment bilateral correlations are lower in the
CCC model (0.27) than in the BGG model (0.38) without banking globalization, they
become higher in the CCC model (0.71) than in the BGG model (0.46) under banking
globalization.
To examine the e¤ect of globalization in more detail, Figures 22 and 23 illustrate GDP
bilateral correlations for a wide range of openness parameter values. The horizontal
axis represents varying trade openness parameter values ( ), FIs’ borrowing openness
parameter values in the IF contract ( F ), and FIs’ lending openness parameter values
in the FE contract ( E ) with the other parameter values …xed. Each row represents
di¤erent shocks. For the productivity shock and the monetary policy shock, bilateralcorrelations increase, as either trade or …nancial openness increases. That increase is
22Previous literature often assumed positive bilateral correlations for structural shocks. It is 0.3 forthe technology shock and 0.6 for the monetary policy shock in Faia (2007).

16

steeper in the CCC model than in the BGG model. For the net worth shocks, changes
in trade and …nancial openness have small impacts on bilateral correlations, except for
one case: when FIs’lending openness ( E ) changes. As the top-right panel of Figure 23
shows, the slope of bilateral correlations is the steepest of all the shocks and openness
parameters. When E = 0:5; the bilateral correlation reaches one; GDPs in the twocountries are perfectly correlated. Because FIs in one country lend the same amount offunds to entrepreneurs in the two countries, FIs’net worth shock has equall impacts on
the two countries.

5

Concluding Remarks

This paper develops a model to explain business cycle synchronization in the economy
where the …nancial market and the real economy are linked globally. Both FIs andentrepreneurs are credit-constrained. Credit contracts are chained between investors,
FIs, and entrepreneurs, and signed globally. Our main …ndings are, …rst, that our model
predicts a positive bilateral correlation. Second, the correlation increases as either trade
or …nancial openness increases. Third, the correlation predicted by our model is greaterthan that by the BGG model in which FIs are not credit constrained.
We draw several implications. The …rst concerns the nature of the recent …nancial
crisis. The recent …nancial crisis that originated in the United States spread immediately
throughout the world. World investment and GDP dropped. The …nancial markets andthe …nancial system were destabilized, which caused a deterioration in FIs’credit conditions, widened credit spreads, and contracted cross-border lending. Those simultaneous
collapses of the world economy both on the trade and …nancial sides are often considered
to be related to globalization in both the goods and …nancial markets.
Our simulation suggests that globalization is key to understanding the rapid propagation of the crisis on a global scale. We have shown that economic openness, characterizedby either trade and …nancial openness, increases bilateral correlations between the countries. Under globalization, adverse shocks (the productivity shock, the monetary policy
shock, and the net worth shock in the FI sector) in one country aggravate credit conditions of borrowers in the other country, and shrink the real economy globally. Assetprices decrease, net worths decline, and GDP and investment drop simultaneously. Suchbusiness cycle synchronization is enhanced as globalization intensi…es. This account is
consistent with our experiences in the 2000s. Compared with the bursting of the dotcom bubble in 2000, the recent …nancial crisis had a broader impact. As Figures 3 to
6 illustrate, the underlying factor is rapid globalization, particularly in Europe. As aresult, many European countries such as Iceland and Ireland su¤ered heavily from thesubprime mortgage problem that originated in the United States.23
23Japanese banks were relatively less damaged than U.S. and European banks, but the Japanese
economy experienced deep recessions. It is true that Japanese banks had less …nancial exposure than
European banks. However, as we discussed in calibration, Japan’s …nancial openness may reach 10
percent. Trade openness is not low, which shot up in the 2000s from 10 to 20 percent. Such economic
openness predicts strong bilateral correlations. For example, economic openness of = 0:2; E = 0:065;
E= 0:035 yields a bilateral correlation for GDP as high as 0.43 in response to productivity shocks. It

17

Note that the degree of business cycle synchronization depends on the source ofshocks: productivity shocks, monetary policy shocks, shocks to FIs’net worth, shocks toentrepreneurial net worth, and other shocks not speci…ed in our model. Our model does
not necessarily imply that business cycle synchronization always increases as economic
openness increases. In fact, Table 3 reports non-monotonic changes in observed bilateralcorrelations from 1970 to 2008. Regarding the recent …nancial crisis, our simulation
implies that a credit market shock is an important factor. For the productivity shockand the net worth shock in the FI sector, our model predicts positive correlations for
GDP, investment, and asset prices. However, of the two shocks, only the net worth shockin the FI sector among them accounts for a simultaneous decline in cross-border lending
and rise in external …nance premiums, which are consistent with actual responses shownin Figures 1 and 2. In this respect, the FIs’ net worth shock is key to understanding
the recent …nancial crisis. Furthermore, in terms of their economically important e¤ects,
FIs’credit constraint is also key.
The second implication concerns policy. As globalization intensi…es, policy has agreater global impact. In the recent …nancial crisis, a number of policy initiatives wereconducted. For example, the Fed slashed its policy rates consecutively. According to
the model, under globalization, the Fed’s domestic policy helps mitigate the downturnin foreign countries. A negative result is, however, that globalization reduces the e¤ectiveness of monetary policy in one country on the country. Using the model, we canevaluate e¤ects of the pegged exchange rate policy and the currency swap program thatwere implemented by central banks in collaboration with the Fed.
Besides monetary policy, our model enables us to evaluate the e¤ects of various
policies. Capital injection policy was implemented to support the …nancial markets andthe …nancial system. In our model, capital injection policy to FIs or entrepreneurs
is simulated as a positive shock of FIs’ or entrepreneurial net worth. Under banking
globalization, capital injection policy plays an important role in in‡uencing the world
economy.
Finally, our model enables us to investigate developments in foreign assets and global
imbalances, and their e¤ects on the …nancial market and the real economy.24 It would
be interesting for future research to investigate how welfare changes if two countries
with di¤erent …nancial technology are interconnected with di¤erent degrees of banking
globalization.

accounts for about half of the observed correlation in the 2000s between Japan and the United States,that is, 0.81. Considering that simulated productivity shocks are completely uncorrelated and equallylarge in two countries, either correlated productivity shocks or the occurrence of extremely large shocks
in the U.S. economy yield a bilateral correlation that is even closer to the observed one.
24
See Caballero, Farhi, and Gourinchas (2008) and Mendoza, Quadrini, and Rios-Rull (2009).

18

A

Model

This Appendix describes the model in detail.

A.1

Credit Market

Environment
There is a continuum number of investors, FIs, and entrepreneurs in the home andthe foreign countries. FIs in the home country sign four credit contracts with investors
and entrepreneurs in the two countries. Two are the FE contracts with investors in thetwo countries, and the other two are the IF contracts with entrepreneurs in the twocountries. In period t, investors collect deposits from a household for the risk-free rate in
the competitive market and lend these deposits to a continuum of FIs. R (st ) and R (st )are the risk-free rate of return paid at the end of period t in the home country and in
the foreign country, respectively, where st is state of the economy in period t. Investors’returns on the loans to FIs are equalized to their opportunity cost given by the risk-freerate. FIs monopolistically supply loans to a continuum of entrepreneurs. Each FI –say,a type-i FI – makes loan contracts with speci…c group of entrepreneurs – say, group-ji
entrepreneurs – that are attached to the FI.25 By lending to a continuum of group-ji
entrepreneurs, type-i FI in the home (foreign) country diversi…es the loan risk associatedwith a speci…c entrepreneur and obtains a return of RF (st ) (RF (st )): Entrepreneurs are…nal borrowers in the economy. Entrepreneurs in the home (foreign) country invest theirEE(st ))(st ) (RH
loans in the purchase of capital goods and receive the return to capital RH
for the home country and RFE (st ) (RFE (st )) for the foreign country.
We de…ne a degree of banking globalization, or …nancial openness, by the allocation of …nance between the home country and the foreign country, which is determinedE
exogenously. When entrepreneurs in the home country borrow funds, 1
H of their
EtE
net worth N (s ) is used to borrow from the home FI and H of their net worth toborrow from the foreign FI. When entrepreneurs in the foreign country borrow funds,EE(st ) is used to borrow from the FI in the country (i.e., the1
F of their net worth N
foreign country) and E
F of their net worth to borrow from the FI in the other countryF(i.e., the home country). FIs in the home country borrow a portion of 1
H from theFhome investors and H from the foreign investors. FIs in the foreign country borrow aFF
portion of 1
F from the investors in the country and F from the investors in the
F
26
E
F
E
other country. Put di¤erently, 0 < H ; H , F ; and F < 1 represent the degree of25

We assume that the bankruptcy cost associated with a credit contract between FI other than type-i
FI and group-ji entrepreneurs is high enough. Therefore, group-ji entrepreneurs can borrow funds only
from a certain monopolistic FI.
26
In equilibrium, investors’ and FIs’ returns from investing in the home country equal those frominvesting in the foreign country. Up to the …rst order, therefore, the portfolio choice becomes indeterminate, and we set the portfolio exogenously. To endogenize the optimal portfolio choice of each country’s
investors, a second-order approximation might be needed as in Dedola and Lombardo (2009), Devereux
and Sutherland (2009), and Devereux and Yetman (2009). However, our model is more complex, because investors, FIs, and entrepreneurs are risk neutral, and goods are traded by debt contracts withdefaults. Also note that although the allocation of net worth used for borrowing from home and foreign
lenders is exogenous, the allocation of borrowings between the two lenders is endogenously determined.

19

banking globalization from FIs’ borrowing and lending sides: FH and FF capture thedegree of banking globalization from FIs’borrowing side, or the …nancial openness of theEinterbank market, and E
H and F capture the degree of banking globalization from FIs’lending side or the …nancial openness of foreign direct investment.
FE contract
We begin with the FE contract between FIs in the home country and entrepreneursin the home country. At the beginning of each period, each type-i FI in the homecountry o¤ers a loan contract to group-ji entrepreneurs in the home country. EachE
entrepreneur in group ji owns net worth N E (st ) :27 It uses 1
H of the net worth toEttt
purchase capital of (1H )Q (s ) KH (s ), where Q (s ) is the price paid to capital inEtunits of the household consumption index. (1H )KH (s ) is the quantity of capitalpurchased by a group-ji entrepreneur: Following BGG, we assume that entrepreneurs
t+1
are subject to an idiosyncratic productivity shock ! E) so that the net return to
H (s
t+1
E
t+1
capital is ! E
(s
)
R
(s
)
:
The
FE
contract
speci…es(1)
the amount of debt that
H
H
E
t
t
a group-ji entrepreneur borrows from type-i FI, (1N E (st )); (2)H )(Q (s ) KH (s )
t+1 t
E
t+1
js ) ;
the cut-o¤ value for the idiosyncratic shock ! H (s ) ; which we denote by ! E
H (s
E
t+1 t
E
t+1
such that entrepreneurs repay their debt for ! H (s )! H (s js ) and declare the
E
t+1 t
E
t+1
default for ! H (s ) < ! H (s js ) ; and (3) a loan rate that group-ji entrepreneurs repayEwhen they do not default, ZH(st+1 jst ) : Ex post, the non-default entrepreneur ji receives
t+1 t
E
E
E
t+1
js ) RH(st+1 ) Q (st ) KH (st ) and the default entrepreneur
(1
) !E
H (s
H ) ! H (sreceives nothing from the contract.
There is a participation constraint for entrepreneurs in the FE contract. Instead ofparticipating in the FE contract, group-ji entrepreneurs can purchase capital goods using
their own net worth N E (st ) ;without participating in loan contracts with FIs. In this alE
t+1
E
ternative case, the ex post return to their investments equals (1 E
) RH
(st+1 ) N E (st ).
H )! H (sTherefore, an FE contract between an FI and entrepreneurs is agreed only when the following inequality is expected to hold:share of entrepreneurial earnings paid to entrepreneur ji

z
1

E
t

}|
{
E
t+1 t
! H s js

E
RH
st+1 jst Q st KH st

E
RH
st+1 jst N E stfor 8ji ; st+1 jst ;

(3)

where
expected productivity of defaulted borrowers
t+1 t
js
t ! s

z
}|
{
Gt ! st+1 jst

portion of non-defaulted borrowers+! st+1 jst
27

z
Z
1

}|

!(st+1 jst ){dFt (!);Net worth depends on group ji ; but in what follows we do not indicate the subscript of ji forsimplicity. The same applies to capital K and idiosyncratic productivity shock !:20

Gt ! st+1

js

Z !(st+1 jst )t!dFt (!) :0

ENote that 1
t is the expected share of pro…ts from purchasing capital goods that
goes to the borrowers in the FE contract. The left-hand side of the inequality (3) showsthe expected return from the FE contract for group-ji entrepreneurs, and the right-handside of the inequality (3) shows the expected return from investing the entrepreneurial
net worth N E (st ) : Credit contracts are signed only when the inequality holds.
Similarly, a participation constraint for entrepreneurs in the FE contract between FIs
in the home country and entrepreneurs in the foreign country is described asshare of entrepreneurial earnings paid to entrepreneur ji

z
1

E
t

}|
{
t+1 t
!E
s
js
H

E
RH

st+1 jst Q

s t KH s t

E
RH
st+1 jst N E stfor 8ji ; st+1 jst :(4)

Variables with the superscript correspond to those in the foreign country. For example,
Et
H KH (s ) represents the quantity of capital purchased by entrepreneurs in the foreigncountry using loans from the FI in the home country. Q (st ) is the price paid to capitalin units of the household consumption index in the foreign country.
The inequality (3) and (4) gives the expression for the expected earnings of a type-i
FI from each of the FE contract
share of entrepreneurial earnings paid to type-i FI

z

}|
{
t+1 t
!E
s
js
H

E
t

(1

E
E
H )RH

st+1 jst Q st KH st

share of entrepreneurial earnings paid to type-i FI

+

z

E
t

!E
H

}|
{
t+1 t
s js

E
t+1 t
E
js )RHF e(sst+1 jst Q

s t KH s t ;where e(st ) represents a real exchange rate. The …rst term indicates earnings fromthe FE contract with entrepreneurs in the home country. The second term indicatesearnings from the FE contract with entrepreneurs in the foreign country. The earnings
are converted from units of the household consumption index in the foreign country tounits of the household consumption index in the home country with their relative priceof e(st+1 jst ): t represents a net lender’s share, de…ned ast! st+1 jstt! st+1 jst

Gt (! i;t+1 ) :A parameter (0 < < 1) represents the parameter of monitoring costs. In particular,
E
F
F
E
E
we de…ne four parameters: E
H ; F ; H ; and F : The parameter H ( F ) represents thecost to monitor entrepreneurs by FIs in the home (foreign) country. The parameter FH( FF ) represents the cost to monitor FIs by investors in the home (foreign) country.
Because each type-i FI lends a continuum number of entrepreneurs in group ji ; theloan risk of the FI is perfectly diversi…ed. For convenience, we de…ne the expected returnon the loans to entrepreneurs, RF (st+1 jst ) by
21

+

Z

Z

E
t

E
t

t+1 t
!E
js
H s

ji

ji

t+1 t
!E
js
H s

RF st+1 jst

E
E
H )RH

(1

st+1 jst Q st KH st dji

jst ) ERHe(st )

E e(s
F

t+1

st+1 jst e(st )Q

E
t
t
(1
H )(Q (s ) KH (s )Ett
+ F e(s )(Q (s ) KH (st )st KH st dji

N E (st ))N E (st ));for 8st+1 jst :(5)

The left-hand side of equation (5) is the gross pro…t that a speci…c type-i FI receives froma continuum number of FE contracts with group-ji entrepreneurs in the two countries.
ttt
On the right-hand side of the equation, E
N E (st )) represents
F e(s )(Q (s ) KH (s )loans to entrepreneurs in the foreign country in units of the household consumption
index in the home country.
t+1 t
The relationship between the cut-o¤ value ! Ejs ) and non-default entrepreneurs’
H (s
E
t+1 t
loan rate ZH (s js ) is given by
t+1 t
E
E
!E
js RH
st+1 jst Q st KH st = ZH
st+1 jst
H s

Q s t KH s t

N E st:(6)
Similarly, for the FE contract between FIs in the home country and entrepreneurs in theE(st+1 jst ) as
foreign country, we obtain ZH
t+1 t
E
!E
js RH
H s

st+1 jst QE
s t KH s t = Z H

st+1 jst

Q

s t KH s t

NE

st

:
(7)

IF contract
We next turn to the IF contract. A type-i FI splits these gross pro…ts from the FE
contract with investors according to another credit contract, the IF contract. The IF
contract has the same costly state veri…cation structure as does the FE contract, whereas
FIs now need to act as the borrowers rather than lenders. In the IF contract, investors
lend the loans to a continuum number of FIs. Each type-i FI in the home country owns
the net worth N F (st ) ; and invests in the loans to group-ji entrepreneurs in the homeEttcountry an amount (1N E (st )) and group-ji entrepreneurs in the
H )(Q (s ) KH (s )Ettforeign country an amount F (Q (s ) KH (s ) N E (st )): The type-i FI then borrowsF
the rest from investors in the home country by a portion of 1
H and investors inFthe foreign country by a portion of H . It repays the loan using its pro…t from the
FE contracts. We assume that the type-i FI is subject to idiosyncratic productivity
shock ! FH (st+1 ) 28 and its ex post gross return on the loans to entrepreneurs is given by
28

FI’s idiosyncratic productivity shock ! F
i is associated with the shock in bankruptcy costs, technology of …nancing short-term assets and liabilities, or the quality of borrowers in the FE contract thatFdi¤ers across FIs. We assume that two variables ! E
ji and ! i are unit mean, lognormal random variables
distributed independently over time and across entrepreneurs and FIs. We express the density function
Eof these variables as ftE ! E
and ftF ! F!Eandii ; and their cumulative distribution functions as FtiFF
Ft ! i :22

! FH (st+1 ) RF (st+1 ) : Here, the IF contract speci…es (1) the amount of debt that the type-i
FI borrows from investors; (2) the cut-o¤ value for the idiosyncratic shock ! FH (st+1 ) and! FH (st+1 ) ; which we denote by ! FH (st+1 jst ) and ! FH (st+1 jst ) ; such that FIs repay theirdebt for ! FH (st+1 )! FH (st+1 jst ) and declare the default for ! FH (st+1 ) < ! FH (st+1 jst ) ;Fand (3) the return rate of the loan when type-i FI does not default, ZH(st+1 jst ) andF
ZH(st+1 jst ) :Similar to the FE contract, there is a participation constraint for the investors in
the IF contract. Given the risk-free rate of return in the economy R (st ) and R (st ) ;investors’pro…t from the investment in the loans to the FIs must equal the opportunity
cost of lending. That is,Ft! FH st+1 jst

RF st+1 jst (1

E
t
t
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )FH)t

N E (s ))N E (st ))F
H)

R st (1tt
E
N E (st ))(1
H )(Q (s ) KH (s )ttt
N E (st )) N F (st )+ E
F e(s )(Q (s ) KH (s )Ft

! FH st+1 jst

RF st+1 jst

t
t
E
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )

;

(8)

:

(9)

F
H
E

N (st ))N E (st ))e(st+1 jst )R st FHe(st )tt
E
N E (st ))(1
H )(Q (s ) KH (s )
t
t
t
+ E
N E (st )) N F (st )F e(s )(Q (s ) KH (s )Expected net pro…ts for the type-i FI in the home country are expressed byX

share of FIs earnings paid to FIs

st+1 jst

st+1

+

z
1

F
t

}|
{
! FH st+1 jst (1

E
t
t
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )

X
st+1

F
F
H )R

st+1 jst

N E (st ))N E (st ))share of FIs earnings paid to FIs

zt+1 t
s js 1

F
t

}|
{
F
t+1 t
F F
! H s js
st+1 jst
HR

E
t
t
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )23

N E (st ))N E (st ))

;

(10)

where (st+1 jst ) is a probability weight for state st+1 ; depending on the information set
available at period t:
Equations (5), (8), and (9) give equation (1) in the main text. To be more precise,the external …nance premium depends on other variables such as the real exchange rate
and the risk-free rate in the other country.
The relationship between the cut-o¤ values ! FH (st+1 jst ) and ! FH (st+1 jst ) and nonFF
default FIs’loan rates ZH(st+1 jst ) and ZH(st+1 jst ) is given by! FH st+1 jst RF st+1 jst

E
t
t
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )F
= ZH
st+1 jst

(1

+

E
t
F e(s )(QEtt
H )(Q (s ) KH (s )tt(s ) KH (s ) N E! FH st+1 jst RF st+1 jst

E
t
t
(1
H )(Q (s ) KH (s )
t
t
t
+ E
F e(s )(Q (s ) KH (s )F
= ZH

N E (st ))N E (st ))N E (st ))(st )) N F (st )

;

(11)

;

(12)

N E (st ))N E (st ))st+1 jsttt
E
N E (st ))(1
H )(Q (s ) KH (s )
t
t
t
+ E
N E (st )) N F (st )F e(s )(Q (s ) KH (s )Optimal credit contract
E
E
Expected returns to capital RH(st+1 jst ) and RH(st+1 jst ) are derived by solving theEE(st+1 jst ) are hereafter called cost-of-funds.
(st+1 jst ) and RH
optimal credit contract. RH
They represent the cost for entrepreneurs in the home country to borrow funds from FIs inE(st+1 jst )the home country and FIs in the foreign country, respectively. A di¤erence of RH
E
t+1 t
and RH (s js ) from the risk-free rate is called the external …nance premium. A type-i
FI in the home country maximizes its expected pro…t (10) by optimally choosing theEvariables ! FH ; ! FH ; ! E
H ; ! H ; KH ; KH ; subject to the investors’participation constraints

24

(8) and (9) and entrepreneurial participation constraints (3) and (4). We obtain
X
E
E
E0
E0 E
0=
st+1 jst RH
st+1 jst
1
t
t + t
t
st+1 jst

(1

+

(1

F
F0
H) t
F0
t

F
H)

1

E
t

1

F
t

+

F
H

F
t

E0 E
t RH

F
t

1

st+1 jst +

E E
t RH

E0
t

F
t

F
t

E E
t RH

st+1 jst

E0tt R(s )

+

F
H

F 0
t
F 0
t

1

E0 E
t RH

F
t

E
t

st+1 jst +E0tst+1 jst

t+1)
E0 e(sR (st )tte(s )for 8ji ;
0=

(13)

X

st+1 jst+(1

st+1 jst
F
F0
H) t
F0
t

E
RH

st+1 jst

1

(1

F
H)

F
t

1

E
t

1
F
t

E 0
+
t

E
t

+

E 0 E
t RH

F
H

1

E 0
t

E
t

F
t

st+1 jst +

E 0
t

F
t

E
E
t RH

F
t

E
E
t RH

st+1 jst

E 0tt R(s )

+

F
H

F 0
t
F 0
t

1

E
t

F
t

E 0 E
t RH

st+1 jst +E 0tst+1 jst

t+1)
E 0 e(sR (st )tte(s )for 8ji :(14)

In the contract with entrepreneurs in the home country, the ratio of capital KH to
net worth is the same across FIs and entrepreneurs. Similarly, in the contract withentrepreneurs in the foreign country, the ratio of capital KH to net worth is the sameacross FIs and entrepreneurs. That facilitates aggregation.
Dynamic behavior of net worth
The net worths of FIs and entrepreneurs, N F (st ) and N E (st ) ; depend on theirearnings from the credit contracts and their labor income. In addition to the pro…ts
from entrepreneurial projects, both FIs and entrepreneurs inelastically supply a unit oflabor to …nal goods producers and receive labor income W F (st ) and W E (st ). We assume
that each FI and entrepreneur survives to the next period with a constant probability
Fand E ; then the aggregate net worths of FIs and entrepreneurs are given by
N F st =F

V F st + W F st + "nF st ;(15)

N E st =E

V E st + W E st + "nE st ;

(16)

25

with
V F st1+

V E st! FH st

F
F
st
H )R
E
t 1
(1
) KH (st 1 ) N E (st 1 ))H )(Q (st 1
+ E)(Q (st 1 ) KH (st 1 ) N E (st 1 ))
F e(s
F F
F
t
F
st
1
HR
t 1 !H s
E
t 1(1) KH (st 1 ) N E (st 1 ))H )(Q (sE
t 1
t 1
+ F e(s )(Q (s ) KH (st 1 ) N E (st 1 ))

1
+ 1

F
t 1

(1

E
E
t
t 1 !H sEtEt 1 !F s

(1

;

(17)

E
E
t
t 1
KH s t 1
H )RH s Q s
E E
t
t 1
KF s t 1 :H RF s Q s(18)F
V F (st ) andFIs and entrepreneurs that fail to survive at period t consume 1
EEt1V (s ) ; respectively. Following Gilchrist and Leahy (2002), we consider "nF (st )and "nE (st ), once-and-for-all changes in the FI’s and entrepreneurial net worth.

A.2

Goods Market

HouseholdA representative household in the home country is in…nitely lived, and maximizes thefollowing utility function:
98
1< C st+l 1
t+l 1+ 1 =
X
H s
t+l
max
E
;
(19)
t
2
: 1
;
C(st );H(st );D(st );B (st )
1+ 1
l=0

1

subject to the budget constraint

C st + D st + e(st )B st
W st H st + R st 1 D st 1 + R

st 1 e(st )B

st 1 +st

T st :C (st ) is …nal goods consumption given by
C st = (1

1=
CH
H)

st

(

1)=

+

1=
H CF

st

(

1)=

=(

1)

;

(20)

where CH (st ) and CF (st ) denote the consumption of home-produced goods spent in
the home country and the consumption of foreign-produced goods spent in the homecountry, respectively. H (st ) is hours worked. P (st ) is the aggregate price of the …nal
goods given by
P st = (1

H )PH

st

1

+

H PF

st

1

1=(1

)

:

(21)

W (st ) is the real wage in units of the household consumption index, and T (st ) is the
lump-sum transfer. R (st ) and R (st ) are the real risk-free return from the deposit26

D (st ) and B (st ) between time t and t + 1. Parameters 2 (0; 1) ; 1 ; and 2 are thesubjective discount factor, the elasticity of leisure, and the utility weight on leisure. A
parameter represents the elasticity of substitution between home-produced goods andforeign-produced goods. Bond markets are complete; bonds are contingent on the set ofaggregate states. The ratio of the marginal utility of consumption in the home country
to the marginal utility of consumption in the foreign country becomes proportional to
the real exchange rate. D (st ) is real domestic deposits held by investors, and B (st ) isreal foreign deposits held by investors.
Trade openness is captured by H : The parameter H represents the weight on foreignproduced goods. Similarly, we de…ne the weight on home-produced goods in the foreigncountry as F . Those parameters indicate the inverse degree of a home bias.
Final goods producer
The …nal goods YH (st ) are composites along a continuum of retail goods YH (h; st ) :The …nal goods producer purchases retails goods in the competitive market and sells
the output to a household and capital producers with price PH (st ). The production
technology of the …nal goods is given by
YH s

t

=

Z 1

YH h; st

1

1

dh

;

(22)

:

(23)

0

where > 1: The corresponding price index is given by
PH s

t

=

Z 1

1

PH h; s

t 1

1

dh

0

Retail goods producer
The retail goods producers h 2 [0; 1] are populated over a unit interval, each producing di¤erentiated retail goods YH (h; st ) ; with production technology
YH h; st = yH h; st ;(24)

where yH (h; st ) for h 2 [0; 1] are the wholesale goods that is used for producing theretail goods YH (h; st ) by the retail goods producer h 2 [0; 1] : The retail goods producers
are price takers in the input market and choose their inputs taking the input priceP (st )=XH (st ) as given. They are monopolistic suppliers in their output market, andset their prices to maximize pro…ts. Consequently, the retail goods producer h faces a
downward-sloping demand curve:
YH h; st =PH (h; st )PH (st )YH s t :The retail goods producers are subject to nominal rigidity. They can change prices
in a given period only with probability (1) ; according to Calvo-type price stickiness.

27

Denoting the price set by the active retail goods producers by PHO (h; st ), retailer h ’s
optimization problem with respect to its products’price PHO (h; st ) is written as follows:
1
X

l l

Et

l=0

PHO (h; st ) YH h; st+l
P (st+l )!
1
P st+l
YH h; st+l C
XH (st+l )C
C = 0:C
P (st+l )A

C st+lC (st )

Using equations (22) ; (23) ; and (24) ; …nal goods YH (st ) produced in period t are
expressed with wholesale goods produced in period t as the following equation:

yH s

t

=
=

Z 1

"0Z

t

yH h; s dh =

Z 1
0

1

0

t

PH (h; s )PH (st )PH (h; st )P (st )# H

YH st dhdh YH st :(25)

Because of the stickiness of the retail goods price, the aggregate price index for the…nal goods PH (st ) evolves according to the law of motion below:
PH s t1= (1) PHO h; st

1+ PH s t 1

1:

Wholesale goods producer
The wholesale goods producers produce wholesale goods yH (st ) and sell them tothe retail goods producers with the relative price 1=XH (st ) : They hire three types oflabor inputs H (st ) ; H F (st ) ; and H E (st ) ; and capital K (st 1 ) : Those labor inputs aresupplied by household, FIs, and entrepreneurs for wages W (st ) ; W F (st ) ; and W E (st ) ;respectively. Capital is supplied by home (foreign) entrepreneurs with the rental priceE
RH(st ) (RFE (st )). At the end of each period, the capital is sold back to the entrepreneurs
at price Q (st ) : The price of a unit of capital Q (st ) is the same for KH (st 1 ) andKF (st 1 ) :29 The maximization problem for the wholesale goods producer is given by1y H styH (st );K(st 1 );H(st );H F (st );H E (st ) XH (st )t 1
E++Q st f(1H )KH s
max

Q s

t 1

(1

W st H st

EtE
H )RH s
F
t

W

29

E
H KF
t 1

KH s

s H F stst 1 g (1

)

W

st ;

E
t
+ E
H RF sEt
E

s H

KF s t 1(26)

For capital supplier’s point of view, entrepreneurs in the home country provide the wholesale goods
producers with KH st 1 and KF st 1 by borrowing funds from FIs in the home country and FIs in
the foreign country, respectively.

28

subject to
E
H )KH

K st

= (1

y H st= A exp eA st
H F stst +F (1K st 1
)

st ;

E
H KF

H E st

H st
E (1

)

(27)
(1

E )(1

F

)

(28)

;

where A exp eA (st ) denotes the level of technology of wholesale production. 2 (0; 1],; F ; and E are the depreciation rate of capital goods, the capital share, the share of
FIs’labor inputs, and the share of entrepreneurial labor inputs.
Capital goods producer
The capital goods producers own the technology that converts …nal goods to capital goods. In each period, capital goods producers in the home country purchase I (st )amounts of …nal goods from the …nal goods producers in the home country. In addition,
they purchase K (st 1 ) (1) of used capital goods from the entrepreneurs in the homecountry at price Q (st ). They then produce new capital goods K (st ) ; using the technology FI ; and sell them in the competitive market at price Q (st ) : Consequently, thecapital goods producer’s problem is to maximize the following pro…t function:

max
t
I(s )

1
X

Et

st+l

Q st+l1

FI I st+l ; I st+l 1

I st+l

I st+l

;

(29)

l=0

where FI is de…ned as follows:
FI I st+l ; I st+l 1

2

I st+lI (st+l 1 )

!2

1

:

Note that is a parameter associated with investment technology with an adjustment
cost.30 Here, the evolvement of the total capital available at period t is described as
K st = 1

FI I st ; I st 1

I st + (1) K st 1 :(30)

Resource constraint
The resource constraint for …nal goods is written asEE
st + CHY st = CH st + CH st + I st + G st + CH

st ;

(31)

E
E
where CH(st ) and CH(st ) represent the consumption of home-produced goods spent in
the home country and the foreign country, respectively. In order to isolate the asymmetry
30

Equation (29) does not include a term for the purchase of the used capital K st 1 from theentrepreneurs at the end of the period. This is because we assume, following BGG, that the price of oldcapital that the entrepreneurs sell to the capital goods producers, say Q (st ) ; is close to the price of the
newly produced capital Q (st ) around the steady state.

29

arising from di¤erences in monitoring costs and consumption by entrepreneurs and FIs,
we assume that monitoring costs and consumption by entrepreneurs and FIs are spentequally between two countries:
ECH
st = 0:5

PH (st )P (st )

Y E st ;(32)

where monitoring costs and consumption by entrepreneurs and FIs in the home countryare
Y E st

=

E

E
t
GE
t !H s

Et 1
KH s t 1
H )Q sEtE
s t 1 KH s t 1+ E GEst Ee(st 1 )RH
FQ
t !H sFF+ F GFt ! FH st (1
st
H )R
E
t 1
(1
) KH (st 1 ) N E (st 1 ))H )(Q (sE
t 1
t 1
+ F e(s )(Q (s ) KH (st 1 ) N E (st 1 ))F
t 1
+ F GFt ! FF st)RF stF e(st 1
1=e(st 1 ) E) KF (st 1 ) N E (st 1 ))H (Q (sEt 1+(1) KF (st 1 ) N E (st 1 ))F )(Q (s
E
E
t
F
F
t

+(1

)V

E
RH
st (1

s + (1

)V

s :

(33)

The …rst two terms on the right-hand side of the equation correspond to the bankruptcy
costs spent by FIs. The third and the fourth terms correspond to the bankruptcy costs
incurred by investors. The last two equations are the FIs’and entrepreneurial consumpE(st ) and Y E (st ) are de…ned.
tion. Similarly, CH

A.3

Rest of the Economy

Government
The government collects lump-sum tax from the household T (st ) ; and spends G (st ).
A budget balance is maintained for each period t: Thus, we have
G st = T st :(34)

Monetary authority
The monetary authority sets the nominal interest rate Rn (st ) ; according to a standard Taylor rule with inertia

Rn st = Rn st 1 + (1

)

H

st +

y log

Y (st )
Y

+ "R st ;(35)

where is the autoregressive parameter of the policy rate,
and y are the policy
weight on in‡ation rate of …nal home-produced goods, and output gap log (Y (st ) =Y ) ;30

respectively. H (st ) denotes the in‡ation rate of home-produced goods at period t, thatis, H (st ) = PH (st ) =PH (st 1 ) :Because the monetary authority determines the nominal interest rate, the real interest
rate in the economy is given by the following Fisher equation:
R st

Rn (st )(st+1 )

Et:(st ) denotes the aggregate in‡ation rate at period t, that is,(36)(st ) = P (st ) =P (st 1 ) :Exogenous variables
The exogenous shocks to the model are the productivity shock, the monetary policy
shock, FIs’ net worth shock, and entrepreneurial net worth shock. The productivity
shock follows the process as
eA st =AAe

st 1 + "A st ;(37)

where A 2 (0; 1) is the autoregressive root. "A (st ) ; "R (st ) ; "nF (st ) ; and "nE (st ) are innovations that are mutually independent, serially uncorrelated, and normally distributedwith mean zero, respectively.
See Appendix B for the summary of the full model.

31

B

Summary of the Model

This Appendix summarizes the model in the home country. The model in the foreigncountry is depicted in the same way.

B.1

Welfare1+ 1

1H (st )2
1+ 1

C (st )U (s ) =
1
t

t

(38)

;

1

t

W (s ) = U (s ) + W (s

B.2

1

t+1

(39)

):

Credit Market

Participation Constraints of Investors
F F
HR

st

(1

E
H )(Q

s t 1 KH s t 1

N E st 1 ) +

E
t 1
)(Q
F e(s

s t 1 KH s t 1

NE

st 1 )

R st 1
(1
+

F
F
H R

st

(1

E
H )(Q

E
t 1
)(Q
F e(s

E
t 1
) KH (st 1 )H )(Q (st 1(s ) KH (st 1 ) N E

s t 1 KH s t 1e(st )Re(st 1 )N E st 1 ) +N E (st 1 ))(st 1 )) N F (st 1 )

E
t 1
)(Q
F e(s

;

(40)

s t 1 KH s t 1

NE

st 1

E
t 1
(1
) KH (st 1 ) N E (st 1 ))H )(Q (st 1
+ E)(Q (st 1 ) KH (st 1 ) N E (st 1 )) N F (st 1 )
F e(s
E
H (1

+

E
F

E
H

E
E
H )RH

e(st ) ERe(st 1 ) H

+

(41)

s t Q s t 1 KH s t 1
st e(st 1 )Q

s t 1 KH s t 1

E
t 1) KH (st 1 )H )(Q (sE
t 1)(Q (st 1 ) KH (st 1 )
F e(s

(1

R F st;N E (st 1 ))N E (st 1 ))

:

(42)

Participation Constraints of Entrepreneurs
1
1

E
H
E
H

Q s t 1 KH s t 1
Q

s t 1 KH s t 1
32

N E st 1 ;

(43)

NE

(44)

st 1 :

st 1 )

Optimal Credit Contracts
E
st+1
0 = RH

E
H

1

(1
+

E0
E0
H + H
F
H) 1

E
H
F
H

+

E
H

F
H

E0 E
H RH

F
F0
H) H
F0
H

(1

1

F
H

F
H

1

st+1 +

E0
H

F
H

E E
H RH

F
H

E E
H RH

st+1

E0
H R(st )

+

F
H

F 0
H
F 0
H

E
H

1

F
H

E0 E
H RH

st+1 +

t+1)
E0 e(sR (st )
H
t

;

E 0
H +
F
H) 1

F
H

e(s )

E
0 = RH

st+1

E
H

1

(1
+

F
F0
H) H
F0
H

(1

E
H

1

E 0 E
H
H
F
H +
F
H

E 0 E
H RH

E0
H

st+1
(45)

F
H

1

st+1 +

E 0
H

F
H

F
H

E
E
H RH

E
E
H RH

st+1

E 0
H R(st )

+

F
H

F 0
H
F 0
H

E
H

1

F
H

E 0 E
H RH

st+1 +

t+1)
E 0 e(sR (st )
H
t

e(s )

E 0
H

st+1
(46)

:

Dynamic Behavior of Net WorthN F st =N E st =V F stFE

V F st +V E st +F
H1

V E stF

1F

H st W st ;(47)

H st W st ;

(48)

E

E

F
F
st
H )R
t 1

(1

E

E
) KH (st 1 )H )(Q (st 1
+ E)(Q (st 1 ) KH (st 1 )
F e(s
F
F F
st
1
HR
H
E
t 1
(1
) KH (st 1 )H )(Q (st 1
+ E)(Q (st 1 ) KH (st 1 )
F e(s

(1

+

F

1

1
+ 1

E
H

(1
E
F

N E (st 1 ))N E (st 1 ))N E (st 1 ))N E (st 1 ))

E
E
t
t 1
KH s t 1
H )RH s Q s
E E
t
t 1
KF s t 1 :H RF s Q s

33

;

(49)

(50)

B.3

Goods Market

Consumption
C st

e st = CC st= C st+1

C st

W st =

CH st = (1Y E st

=

H pF

st

;

(51)

r(st );

(52)

1=

st

2H

H )pH

CF st =

st

st

;

(53)

C st ;(54)

C st ;(55)

E
CH
st = 0:5

PH (st )P (st )

Y E st ;

(56)

CFE

PF (st )P (st )

Y E st ;

(57)

E

s

t

= 0:5

E
t
GE
H RH s (1Et 1
KH s t 1
H )Q st 1
E
s t 1 KH s t 1+ E GE
)RH
st E
FQ
H e(s
F
F
+ F GFH (1
st
H )R
t 1
E
) KH (st 1 ) N E (st 1 ))(1H )(Q (st 1)(Q (st 1 ) KH (st 1 ) N E (st 1 ))
+ E
F e(s
+ F GFF FF e(st 1 )RF st
t 1) KF (st 1 ) N E (st 1 ))1=e(st 1 ) E
H (Q (sEt 1+(1) KF (st 1 ) N E (st 1 ))F )(Q (s
E
E
t
F
F
t

+(1

)V

s + (1

)V

(58)

s :

Capital and Investment
E
RH
st =

Rk (st ) + (1)Q (st );Q (st 1 )(59)

Rk (st ) + (1)Q (st );Q (st 1 )1
H (st ) W (st )R k st =1
1
K (st 1 )FE()
2I (st )I (st )I (st )t
1
Q s
1
2 I (st 1 )I (st 1 )I (st 1 )RFE st =

= 1+
K s

t

=

C (st )C (st+1 )(1

2

Q st+1I (st )I (st 1 )K st = (1I (st+1 )I (st )
)

2

st +

E
H KF

I (st+1 )I (st )

(60)
(61)

1

1 ;

(62)

) K st 1 ;

(63)

2

1

E
H )KH

34

I st + (1

st :

(64)

Productiony H st =
+

H

H

(1

K st 1H stst (YH st

CH st

yH st = A exp eA st

E
CH

CH st

st (YH st

E )(1

F

)

(65)

;

E
CH
st )

st ):

(66)

Price Setting
(1

XH s

t

= (1

H (s ) = (1t

E ) (1Ft

H (s ) = (1A exp eA (st ) K (st 1 ) H (st ))H (st ) W (st )

2

1 "

1

61
)4

1+ H (st )

1

2

1 "

1

61
)4

3""1
7
5

3""1
7
5

1+ H (st )12

C (st+1 )C (st )pKH(st ) =""

1+t
1 pH (s ) XH (st )

1 "

1

1
p
p
t
t 6
KH (s ) = FH (s ) 4

FHp (st ) = 1 +

1+

H

(st )

311"
7
5

1+ H;t

1
"

H (s

t 1

);

(68)

H (s

t 1

);

(69)

"

1

+

(70)

;

(1 + H (st+1 )) YH (st+1 ) p t+1
F (s );
1 + (st+1 )YH (st ) H

C (st+1 )C (st )"+1

(1 + H (st+1 ))
1 + (st+1 )e(st )pH (st ) = pH (st );1+t
H (s ) =1 + (st )1+t
H (s ) = 1 +

1 = (1

H )pH

st

1

(st )
+

)

; (67)t
H (s )

1+

E )(1

"

1

+

F

(71)

YH (st+1 ) p t+1
K (s );YH (st ) H
(72)
(73)

pH (st );pH (st 1 )(74)

pH (st );pH (st 1 )

(75)

H pF

st

1

:

(76)

st ;

(77)

Goods Market Clearing
YH s t= CH st + CH st + I st
E
E
+G st + CH
st + CH

GDPH st

CH st + CH st + I st + G st :
35

(78)

Monetary Policy
Rn st = Rn st 1 + (1)

H

R st =

st +

y log

Rn (st ):(st+1 )36

Y (st )
Y

+ eR st ;

(79)

(80)

C

Parameterization

C.1

Parameterization I

This Appendix provides parameterization of the variables associated with household,wholesalers, capital goods producers, retailers, …nal goods producers, government andmonetary authority. Following precedent studies including BGG and Christiano, Motto,
and Rostagno (2004), we choose conventional values for these parameters.

Parameter

R

1

Value
0.99
0.025
0.35
0.99 1
6
0.75
3
2.5
1

F;

E

a

y

C.2
H
E
H
F
H
F
E
F
F
F

31

0.01
0.8
0.85
1.5
0

Parameters31
Description
Discount factor
Depreciation rate
Capital share
Risk-free rate
Degree of substitutability
Probability that price cannot be adjusted
Elasticity of labor
Adjustment cost of investment
Elasticity of substitution between
home produced goods and foreign produced goods
Share of FIs’and entrepreneurial labor inputs
Autoregressive parameter for the policy rate
Autoregressive parameter for TFP
Policy weight on in‡ation
Policy weight on output gap

Parameterization II (Globalization)
0.15
0
0
0.15
0
0

Globalization parameters in the benchmark
Trade openness in the home country
Banking globalization in FIs’lending to entrepreneurs in the home country
Banking globalization in FIs’borrowing in the home country
Trade openness in the foreign country
Banking globalization in FIs’lending to entrepreneurs in the foreign country
Banking globalization in FIs’borrowing in the foreign country

Figures are quarterly unless otherwise noted.

37

C.3

Parameterization III (Credit Market)

Regarding the parameters in the credit market, we set values for six parameters that arelinked to the IF contract and FE contract so that these values are consistent with thefollowing seven conditions. These are as follows: (1) the risk spread, RE R; equal to
200 basis points annually; (2) the ratio of net worth held by FIs to capital, N F =QK, is0.1, which is close to the actual value according to the data;32 (3) the ratio of net worth
held by entrepreneurs to capital, N E =QK, is 0.5, the approximate value in the data; (4)the annualized failure rate of FIs is two percent;33 and (5) the annualized failure rate ofentrepreneurs is two percent. Conditions (1), (3), and (5) are the same as those used in
BGG. Two more conditions are set to be approximately consistent with the U.S. data:(6) the spread between the FIs’loan rate and the FIs’borrowing rate Z E Z F equals
230 basis points annually, which equals the historical average spread between the prime
lending rate and the six-month certi…cate of deposit rate from 1980 to 2006; and (7) the
spread between the FIs’borrowing rate and risk-free rate Z F R equals 60 basis points
annually, which turns out to be approximately the historical average spread between thesix-month certi…cates of deposit rate and the six-month Treasury bill rate from 1980 to2006.
The estimated parameters from those steady-state conditions include the lenders’bankruptcy cost in the IF contract FH and FF , the lenders’bankruptcy cost in the FE
Econtract E
H and F ; the standard error of the idiosyncratic productivity shock in the
FI sector FH and FF , the standard error of the idiosyncratic productivity shock in theFFE
entrepreneurial sector E
H and F , the survival rate of FIs H and F ; and the survivalErate of entrepreneurs E
H and F .
Calibrated parameters
Parameter Value
Description
0.107 S.E. of FIs’idiosyncratic productivity at steady stateF
0.313 S.E. of entrepreneurial idiosyncratic productivity at steady stateE
FF
0.033 Bankruptcy (monitoring) cost associated with FIs
H; FE
E
0.013 Bankruptcy (monitoring) cost associated with entrepreneurs
H; F
0.963 Survival rate of FIs
F
0.984 Survival rate of entrepreneursE

32

We calculate the steady-state value of N E =QK based on the Flow of Funds data, released by theFederal Reserve Board. We calculate the historical series of the sum of corporate equities and equity innoncorporate business held by …nancial sectors divided by total liability and equity of the non…nancial
business sector, and set at the steady-state value of 0.1 for N E =QK, which is the historical average from1990 to 2005.
33
Although the FI’s failure rate may seem to be lower than the entrepreneur’s failure rate, we setthem to this value based on the observation of the CDS premium data during the recent crisis periods.

38

Steady state conditions
Condition
Description
1
R = 0.99
Risk-free rate
Z E = Z F + 0:023:25 FIs’loan rate
Z F = R + 0:006:25 FIs’borrowing rate
Default probability in the IF contract
F ! F = 0:02
F ! E = 0:02
Default probability in the FE contractFn = 0:1
FIs’net worth/capital ratio
E
n = 0:5
Entrepreneurial net worth/capital ratio

39

References[1] Aikman D. and M. Paustian (2006). “Bank Capital, Asset Prices and Monetary
Policy.”Bank of England working papers 305, Bank of England.
[2] Ambler, S., E. Cardia, and C. Zimmermann (2004). “International Business Cycles:
What are the Facts?”Journal of Monetary Economics, vol. 51(2), pp. 257–276.
[3] Anari A., J. Kolari, and J. Mason (2005). “Bank Asset Liquidation and the Propagation of the U.S. Great Depression.”Journal of Money, Credit, and Banking, vol.
37(4), pp. 753–773.
[4] Ashcraft, A. B. (2005). “Are Banks Really Special? New Evidence from the FDICInduced Failure of Healthy Banks,” American Economic Review, vol. 95(5), pp.
1712–1730.
[5] Backus, D.K., P.J. Kehoe, and F.E. Kydland (1992). “International Real Business
Cycles.”Journal of Political Economy, vol. 101, pp. 745–775.
[6] Backus, D.K., P.J. Kehoe, and F.E. Kydland (1994). “Dynamics of the Trade Balance and the Terms of Trade: the J-curve?” American Economic Review, vol. 84(1), pp.84–103.
[7] Baxter, M. and M.J. Crucini (1995). “Business Cycles and the Asset Structure of
Foreign Trade.”International Economic Review, vol. 36(4), pp. 821–854.
[8] Bernanke, B. S. and A. Blinder (1988). “Credit, Money and Aggregate Demand,”American Economic Review, vol. 78, pp. 435–439.
[9] Bernanke, Ben S., M. Gertler, and S. Gilchrist (1999). “The Financial Accelerator
in a Quantitative Business Cycle Framework.” in Handbook of Macroeconomics, J.
B. Taylor and M. Woodford (ed.), edition 1, vol. 1 (21), pp. 1341–1393.
[10] Bordo, M.D., A.M. Taylor, and J.G. Williamson (2003). Globalization in Historical
Perspective. Chicago: University of Chicago Press.
[11] Burstein, A., C. Kurz, and L. Tesar (2008). “Trade, Production Sharing, and theInternational Transmission of Business Cycles.” Journal of Monetary Economics,
vol. 55(4), pp. 775-795.
[12] Caballero, R.J., E. Farhi, and P-O. Gourinchas (2008). “An Equilibrium Model of‘Global Imbalances’and Low Interest Rates.” American Economic Review, vol. 98(1), pp. 358–393.
[13] Calomiris, C. W. and J. Mason (2003). “Consequences of Bank Distress during theGreat Depression,”American Economic Review, vol. 93, pp. 937–947.
[14] Chen, N. K. (2001). “Bank Net Worth, Asset Prices and Economic Activity.”Journal of Monetary Economics, vol. 48(2), pp. 415-436.
40

[15] Christiano L., R. Motto, and M. Rostagno (2004). “The Great Depression and theFriedman-Schwartz Hypothesis.”Journal of Money, Credit and Banking, vol. 35(6),pp. 1119–1197.
[16] Clarida, R., J. Gali, and M. Gertler (2002). “A Simple Framework for International
Monetary Policy Analysis.” Journal of Monetary Economics, vol. 49(5), pp. 879–904.
[17] Crafts, N. (2000). “Globalization and Growth in the Twentieth Century.” IMF
Working Paper 44, International Monetary Fund.
[18] Curdia, V. and M. Woodford (2009). “Credit Frictions and Optimal Monetary Policy.”BIS Working Papers, 278.
[19] Dedola, L. and G. Lombardo (2009). “Financial Frictions, Financial Integration andthe International Propagation of Shocks.”Draft.
[20] Devereux, M. and A. Sutherland (2009). “Solving for Country Portfolios in Open
Economy Macro Models.” Journal of the European Economic Association, forthcoming.
[21] Devereux, M. and J. Yetman (2009). “Financial Deleveraging and the International
Transmission of Shocks.”Bank for International Settlements Research Papers.
[22] Dib, A. (2009). “Credit and Interbank Markets in a New Keynesian Model,”Draft,
Bank of Canada.
[23] Edison, H.J., M. Klein, L. Ricci, and T. Slok (2004). “Capital Account Liberalizationand Economic Performance: Survey and Synthesis.” IMF Sta¤ Papers, vol. 51(2),pp. 220–256.
[24] Eichengreen, B.J. (2001). “Capital Account Liberalization: What Do Cross-Country
Studies Tell Us?”World Bank Economic Review, vol. 15, pp. 341–365.
[25] Faia, E. (2007). “Finance and International Business Cycles.”Journal of Monetary
Economics, vol. 54, pp. 1018–1034.
[26] Findlay, R. and K. O’Rourke (2003). “Commodity Market Integration, 1500-2000.”in Globalization in Historical Perspective. M.D. Bordo, A.M. Taylor, and J.G.
Williamson (eds), Chicago: University of Chicago Press.
[27] Frankel, J.A. and A.K. Rose (1998). “The Endogeneity of the Optimum Currency
Area Criteria.”Economic Journal, vol. 108, pp. 1009–1025.
[28] Gerali, A., S. Neri, L. Sessa, and F. Signoretti (2008). “Credit and Banking in a
DSGE Model.”Draft, Bank of Italy.
[29] Gertler, M. S. Gilchrist, and F.M. Natalucci (2007). “External Constraints on Monetary Policy and the Financial Accelerator.”Journal of Money, Credit and Banking,vol. 39(2–3), pp. 295–330.
41

[30] Gertler, M. and P. Karadi (2009). “A Model of Unconventional Monetary Policy.”
Draft.
[31] Gertler, M. and N. Kiyotaki (2010). “Financial Intermediaries and Credit Policy inBusiness Cycle Analysis.”Draft.
[32] Gilchrist, S. and J.V. Leahy (2002). “Monetary Policy and Asset Prices.” Journalof Monetary Economics, vol. 49(1), pp. 75–97.
[33] Goldberg, L.S. (2009). “Understanding Banking Sector Globalization.” IMF Sta¤
Papers, vol. 56(1), pp. 171–197.
[34] Goodfriend, M. and B. T. McCallum (2007). “Banking and Interest Rates in Monetary Policy Analysis: A Quantitative Exploration,”Journal of Monetary Economics,
vol. 54(5), pp.1480–1507.
[35] Heathcote, J. and F. Perri (2002). “Financial Autarky and International Business
Cycles.” Journal of Monetary Economics, vol. 49(3), pp. 601–627.
[36] Heathcote, J. and F. Perri (2004). “Financial Globalization and Real Regionalization.” Journal of Economic Theory, vol. 199(1), pp. 207–243.
[37] Hirakata, N., N. Sudo, and K. Ueda (2009). “Chained Credit Contracts and Financial Accelerators.”Discussion Paper Series E-30, Bank of Japan.
[38] Hirakata, N., N. Sudo, and K. Ueda (2010). “Do Banking Shocks Matter for the
U.S. Economy?”Draft.
[39] Holmstrom, B. and J. Tirole (1997). “Financial Intermediation, Loanable Funds,
and the Real Sector.”Quarterly Journal of Economics, vol. 112(3), pp. 663–691.
[40] Iacovielloa, M. and R. Minetti (2006). “International Business Cycles with Domestic
and Foreign Lenders.”Journal of Monetary Economics, vol. 53(8), pp. 2267–2282.
[41] Imbs, J. (2004). “Trade, Finance, Specialization, and Synchronization.” Review of
Economics and Statistics, vol. 86(3), pp. 723–734.
[42] Imbs, J. (2006). “The Real E¤ects of Financial Integration.”Journal of International
Economics, vol. 68(2), pp. 296–324.
[43] Kaminsky, G. and C. Reinhart (2000). “On Crises, Contagion, and Confusion.”
Journal of International Economics, vol. 51(1), pp. 145–168.
[44] Kehoe, P. and F. Perri (2002). “International Business Cycle and Endogenous Incomplete Markets.”Econometrica, vol. 70(3), pp. 907–928.
[45] Kiyotaki, N. and J. Moore (1997). “Credit Cycles.” Journal of Political Economy,
vol. 105(2), pp. 211–248.

42[46] Kiyotaki, N. and M. Gertler (2010). “Financial Intermediation and Credit Policy inBusiness Cycle Analysis.”Draft.
[47] Kose, M.A., E.S. Prasad, K. Rogo¤, and S. Wei (2006). “Financial Globalization:
A Reappraisal,”IMF Working Paper 189, International Monetary Fund.
[48] Kose, M.A., E.S. Prasad, and M.E. Terrones (2003). “How Does Globalization A¤ect
the Syncronization of Business Cycles?” American Economic Review Papers andProceedings, vol. 93(2), pp. 57–62.
[49] Kose, M.A. and K. Yi (2006). “Can the Standard International Business Cycle Model
Explain the Relation between Trade and Comovement?” Journal of International
Economics, vol. 68(2), pp. 267–295.
[50] Maddison, A. (1995). Monitoring the World Economy 1820–1992. Paris: Organization for Economic Coordination and Development.
[51] Maddison, A. (2001). The World Economy: A Millennial Perspective. Paris: Organization for Economic Coordination and Development.
[52] Meh, C. and K. Moran (2004). “Bank Capital, Agency Costs, and Monetary Policy.”
Working Papers 04-6, Bank of Canada.
[53] Mendoza, E.G., V. Quadrini, J-V. Rios-Rull (2009). “Financial Integration, Financial Development, and Global Imbalances.” Journal of Political Economy, vol.
117(3), pp. 371–416.
[54] Morgan, D., P. Strahan, and B. Rime (2004). “Bank Integration and State Business
Cycles.”Quarterly Journal of Economics, vol. 119(4), pp. 1555-1585.
[55] Obstfeld, M. and A.M. Taylor (2004). Global Capital Markets: Integration, Crisis,
and Growth. New York: Cambridge University Press.
[56] Peek, J. and E.S. Rosengren (1997). “The International Transmission of Financial
Shocks: Case of Japan.”American Economic Review, vol. 87(4), pp. 625–638.
[57] Peek, J. and E.S. Rosengren (2000). “Collateral Damage: E¤ects of the JapaneseBank Crisis on Real Activity in the United States.” American Economic Review,
vol. 90(1), pp. 30–45.
[58] Perri, F. and V. Quadrini (2010). “International Recessions.”Draft.
[59] Van den Heuvel, S.J. (2008). “The Welfare Cost of Bank Capital Requirements.”
Journal of Monetary Economics, vol. 55(2), pp. 298–320.
[60] Van Rijckeghem, C. and B. Weder (2003). “Spillovers through Banking Centers: A
Panel Data Analysis of Bank Flows.”Journal of International Money and Finance,
vol. 22(4), pp. 483–509.

43

Table 1: Observed Bilateral Correlations for GDP
1970Q1 to 2008Q4
Japan
Germany
France
Italy
U.K.
CanadaEuro area

U.S. Japan Germany France Italy U.K. Canada
0.23
0.18 0.29
0.50 0.29
0.49
0.34 0.56
0.37
0.66
0.65 0.23
0.05
0.49
0.51
0.75 0.14
0.01
0.46
0.51 0.62
0.36 0.57
0.82
0.73
0.89 0.64
0.53
Note: Detrended with Hodrick-Prescott …lter
Source: IMF, ”InternationalFinancialStatistics.”

Table 2: Observed Bilateral Correlations for Investment
1970Q1 to 2008Q4
Japan
Germany
France
Italy
U.K.
CanadaEuro area

U.S. Japan Germany France Italy U.K. Canada
0.29
0.26 0.41
0.31 0.59
0.57
0.18 0.55
0.48
0.64
0.43 0.37
0.04
0.42
0.44
0.41 0.25
-0.05
0.34
0.25 0.48
0.54 0.73
0.75
0.81
0.80 0.68
0.52

Note: Detrended with Hodrick-Prescott …lter.
Source: IMF, ”International Financial Statistics.”
Table 3: Observed Bilateral Correlations for GDP
for Di¤erent Samples
1970Q1 to 2008Q4
1970Q1 to 1979Q4
1980Q1 to 1989Q4
1990Q1 to 1999Q4
2000Q1 to 2008Q4

U.S. –Japan U.S. –Germany Japan –Germany
0.23
0.18
0.29
0.18
0.75
0.30
0.19
0.08
0.12
-0.33
-0.49
0.26
0.81
0.56
0.65

Note: Detrended with Hodrick-Prescott …lter.
Source: IMF, ”International Financial Statistics.”

44

Table 4: Predicted Bilateral Correlations for GDP

Productivity
shock only

Monetary
policyshock onlyFIs’
net worthshock only

Entrepreneurial
net worthshock only

Benchmark0.28 (0.21)
0.14 (0.12)-0.11 (–)
0.07 (-0.00):( = 0)
Banking
globalization 0.41 (0.21)
0.44 (0.16)
0.30 (–)-0.05 (-0.00)( = 0:1)
Note: Figures in parentheses indicate bilateral correlations predicted by the BGG model.

Table 5: Predicted Bilateral Correlations for Investment

Productivity
shock only

Monetary
policyshock onlyFIs’
net worthshock only

Entrepreneurial
net worthshock only

Benchmark0.53 (0.37)
0.27 (0.38)-0.05 (–)
0.07 (0.21):( = 0)
Banking
globalization 0.81 (0.38)
0.71 (0.46)
0.42 (–)
0.09 (0.20)( = 0:1)
Note: Figures in parentheses indicate bilateral correlations predicted by the BGG model.

45

(2005Q1=100)

120

GDP

Cross-border lending(2005Q1=100)
600

115

500

110

400

US
Japan
EuropeIceland
IrelandDeveloping Countries

300

105
US
Japan
Euro area
Iceland
Ireland

100
95

200
100
0

90
05

06
(2005Q1=100)

190

07

08

05

09

Investment

200
160
140

150

07

08

09

07

08

09

US
Japan
Europe

180
170

06

(2005Q1=100)

120

130

100

110

80
US
Japan
Euro area
Iceland
Ireland

90
70

05

06

50
05

06

07

08

09

Figure 1: Global Downturns in the Recent Financial Crisis (1)Note: Cross-border lending is de…ned as consolidated foreign claims on an immediateborrowers basis.
Sources: IMF, ”International Financial Statistics”; BIS, ”Consolidated International
Banking Statistics.”

46

Stock prices(2005M1=100)

180

Corporate bond spreads (AA)(%)
6
NASDAQ

160

5

NIKKEI

US

FT100
140

4

120

3

100

2

80

1

Japan
Europe

60

0
05

06

07

08

09

05

06
(%)

FIs' net worth (equities)(2005Q1=100)

07

08

09

Corporate bond spreads (BBB)

10

170

9

150
130

8

US

7

Japan

6

Europe

5

110
90
70

US

4

Japan

3

Euro area

2
1
0

50
05

06

07

08

05

09

06

07

08

09

Figure 2: Global Downturns in the Recent Financial Crisis (2)Note: FIs’ net worth is de…ned as ”corporate equities + equity in the noncorporate business sector” held by the …nancial business sector. Corporate bond spreads aredi¤erences between corporate bond rates and government bond rates.
Sources: Bloomberg; Federal Reserve, ”Flow of Funds Accounts”; Bank of Japan,”Flow of Funds Accounts”; European Central Bank, ”Euro Area Integrated Economic
and Financial Accounts.”

47

50
45

(%)

US
Japan

40

Germany
Euro

35
30
25
20
15
10
5
0
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Figure 3: Trade Openness
Note: Trade openness is de…ned as (exports + imports)/2 as a share of GDP (percent).
Source: IMF, ”International Financial Statistics.”

48

25

(trillions of US dollars)
US
Japan
EuropeDeveloping countries

20
15
10
5
0
99 00
120

01

02

03

04

05

06

07

08

09

00
01
02
03
04
05
06
(ratio to non-financial firms' total liabilities, %)

07

08

09

07

08

09

(ratio to nominal GDP, %)US
Japan
EuropeDeveloping countries

100
80
60
40
20
0
99
45
40
35
30
25
20
15
10
5
0

US
Japan
Euro Area

00

01

02

03

04

05

06

Figure 4: Cross-Border Lending
Note: Cross-border lending is de…ned as consolidated foreign claims on an immediateborrower basis. The middle panel indicates the ratio of consolidated claims to nominal GDP at the end of the calendar year. The …gure for 2009 is that of June 2009.
The bottom panel indicates the ratio of consolidated claims to non-…nancial …rms’total
liabilities.
Sources: BIS, ”Consolidated International Banking Statistics”; IMF, ”World Economic Outlook”; Federal Reserve, ”Flow of Funds Accounts”; Bank of Japan, ”Flow ofFunds Accounts”; European Central Bank, ”Euro Area Integrated Economic and Financial Accounts.”

49

10
9
8
7
6

(trillions of US dollars)

10(trillions of US dollars)

9

US
Japan
EuropeDeveloping countries

US
Japan
EuropeDeveloping countries

8
7
6

5

5

4

4

3
3
2
2

1

1

0
19
2099
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09

0
US
Japan

1.0
0.8
0.6
0.4
0.2
0.0

19
2099
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09

Developing countries

Figure 5: Cross-Border Lending to the Non-Bank Private Sector (leftpanel) and Banks (right panel).
Note: Cross-border lending is de…ned as consolidated international claims on an
immediate borrower basis.
Source: BIS, ”Consolidated International Banking Statistics.”

(%)

30

Fund-raising by overseas sector

25

Fund-raising by domestic nonfinancial sector
via overseas markets
Cross-border ratio

20
15
10
5
0
1979

1983

1987

1991

1995

1999

2003

Figure 6: Channels of Fund-Raising by theNon…nancial Sector
Source: Bank of Japan, ”Flow of Funds Accounts.”
50

2007

FirmsI

REj(+1)QKij

Capital producers

QKij
Entrepreneur j in bank i

NFi

FI i

NEij

Loan of QKij-NEij

Entrepreneurs’FIs’

balance sheet

balance sheet

Loan of QKi-NFi-NEi

QK- NF- NE

QK- NE

QK- NE

QK

NF

Investors

NE

Figure 7: Chained Credit Contracts

Investor

Investor

1−τFH

1−τFF

ω FH
FI with NF

τFH

τFF

ωF*H

ω FF

ωF*F
FI with NF*

1−τEH

τEF

ω EH

τEH, ωEF

τEF, ωE*H

ωE*F

REH,, KH

REF,, KF

RE*H,, K*H

RE*F,, K*F

Entrepreneur with NE

Entrepreneur with NE*

Figure 8: Chained Credit Contracts in Two Countries

51

1.03

H

1.03
F

E

τ =τ =0

1.025

F

1.025

F

τ =0.5Eτ =0.5

1.02

1.02

1.015
1.01
-0.05

1.015

0

1.01
-0.05

0.05

F
∆ nF

1.03

H

1.03
1.025

1.02

1.02

1.015

1.015

0

0.05

F
∆ nF

1.025

1.01
-0.05

0

1.01
-0.05

0.05

E
∆ nF

F

0
E
∆ nF

Figure 9: Cost-of-Funds versus Net Worth

52

0.05

H GDP00-0.005
-0.01
5

2

0
-3
x 10

5

10
15
H Investment

-1

20

0

0
-3
x 10

5

0
-3
x 10

5

10
15
F Investment

20

10
H N/QK

15

-1

20

0
-3
x 10

5

10
F N/QK

15

20

1

0

5

10

15

20

0
0

5

0

10
e

15

-1

20

CCC
BGG

-0.005
-0.01

F GDP

-0.5

0
-2

-3

-0.5

0
-5

x 10

0

5

10

15

20

Figure 10: Productivity Shock in H without Banking Globalization

53

H GDP0

5-0.005
-0.01
0

x 10

-4

F GDP

0
0
-3
x 10

5

10
15
H Investment

-5

20

0

0
-4
x 10

5

10
15
F Investment

20

0
-3
x 10

5

10
F N/QK

15

20

0

5

10

15

20

-2

-2

-4
-4
5

0
-3
x 10

5

10
H N/QK

15

20
0

0
-5

-0.5
0

5

0.01

10
e

15

-1

20

CCC
BGG

0
-0.01

0

5

10

15

20

Figure 11: Monetary Policy Shock in H without Banking Globalization

54

0

x 10

-3

H GDP

2

-0.5
-1
0

2

-4

F GDP

0
0
-3
x 10

5

10
15
H Investment

-2

20

2

-1
-2

x 10

0
-4
x 10

5

10
15
F Investment

20

0
-5
x 10

5

10
F N/QK

15

20

0

5

10

15

20

0
0
-3
x 10

5

10
H N/QK

15

-2

20

0
-2

0

-4
-2
5

0
-4
x 10

5

10
e

15

20

CCC
BGG

0
-5

0

5

10

15

20

Figure 12: FIs’Net Worth Shock in H without Banking Globalization

55

0

x 10

-4

H GDP

5

-2
-4
0

-0.5

0
-4
x 10

5

10
15
H Investment

-5

20

5

2

0
-3
x 10

5

10
H N/QK

15

-5

20

-0.5

0
-5
x 10

5

10
15
F Investment

20

0
-5
x 10

5

10
F N/QK

15

20

0

5

10

15

20

-1
0
-4
x 10

5

10
e

15

-1.5

20

CCC
BGG

0
-2

F GDP

0

-1
-1.5

-5

0

-2
-4

x 10

0

5

10

15

20

Figure 13: Entrepreneurial Net Worth Shock in H without Banking Globalization

56

H GDP00-0.005
-0.01
5

2

0
-3
x 10

5

10
15
H Investment

-2

20

0

F GDP

0
-3
x 10

5

10
15
F Investment

20

0
-3
x 10

5

10
F N/QK

15

20

0

5

10

15

20

-1
0
-3
x 10

5

10
H N/QK

15

-2

20

1

0
-2

-3

-1

0
-5

x 10

0
0

5

10
e

0

15

-1

20

-0.005

CCC τ=0.1-0.01

BGG τ=0.1
CCC τ=0

0

5

10

15

20

Figure 14: Productivity Shock in H under Banking Globalization (1)

-4

0

F

-4

x 10 H N /QK

0

-2

-2

-4

-4

F

-3

x 10 F N /QK

2E

x 10 H N /QK

6

-4

E

-3

FQ

x 10 F N /QK

4
1

-6

0

10

20

-6

-4

4

2
0

10

0

20

-4

x 10 H premium2x 10 F premium

2

0

10

x 10

-3

20

HQ

0
1

2

0

0

0

0

-2

-2

-1

-2

-4

-4

0

10

20

0

-3

10

Loan F I to H FI
x 10

10

20

Loan H I to F FI

0.04

0

10

20

Loan F FI to H E

0.02

-2

0.02

0

0.02

0

0

-0.02

0

0

10

20

-0.02

0

10

20

-0.04

0

10

20

-0.02

10

x 10

0

20

10

20

Loan H FI to F E

0.04

5

-5

0

CCC τ=0.1
CCC τ=00

1020

Figure 15: Productivity Shock in H under Banking Globalization (2)57H GDP00-0.005
-0.01
0

5

0
-3
x 10

5

10
15
H Investment

-1

20

0

F GDP

0
-3
x 10

5

0
-3
x 10

5

10
H N/QK

20

15

-2

20

0
-3
x 10

5

10
F N/QK

15

20

2

0

5

10

15

20

0
0

5

10
e

0.01

15

-2

20

CCC τ=0.1

0
-0.01

10
15
F Investment

-1

0
-5

-3

-0.5

-2
-4

x 10

BGG τ=0.1
CCC τ=0
0

5

10

15

20

Figure 16: Monetary Policy Shock in H under Banking Globalization (1)

-3

0

F

-3

x 10 H N /QK

0

F

-3

x 10 F N /QK

2

-2

0

10

20

-2

-3

1

-3

E

-3

FQ

x 10 F N /QK

0

10

1.5

20

Loan F I to H FI

0

0.5

0
0

10

-1

20

0

-3

x 10 H premium

0
-1

1

1
-1

-4
-6

E

x 10 H N /QK

x 10 F premium

1

0
-0.01

0

0

10

20

-0.02

Loan H I to F FI

0

20

HQ

0.01

0.5

10

0
5

0

10

x 10

0

0

10

20

Loan F FI to H E

0.2

-5

0

10

0

-0.03

0

10

20

-0.05

0.1

-0.1

-0.1

0

-0.2

0

10

20

0

10

20

20

Loan H FI to F E

-0.01
-0.02

20

CCC τ=0.1
CCC τ=00

1020

Figure 17: Monetary Policy Shock in H under Banking Globalization (2)

58

0

x 10

-3

H GDP

2

-0.5
-1
0

2

0
-3
x 10

5

10
15
H Investment

-2

20

5

5

F GDP

0
-4
x 10

5

0
-3
x 10

5

10
H N/QK

15

-5

20

0
-4
x 10

5

10
F N/QK

15

20

5

20

0

5

10

15

20

0
0
-4
x 10

5

10
e

15

-5

20

CCC τ=0.1
BGG τ=0.1

0
-5

10
15
F Investment

0

0
-2

-4

0

-1
-2

x 10

0

5

10

15

CCC τ=020

Figure 18: FIs’Net Worth Shock in H under Banking Globalization (1)

-3

-0.5

F

-4

x 10 H N /QK

2

-1

0

-1.5

-2

F

-3

x 10 F N /QK

1

E

x 10 H N /QK

10

-5

E

-4

FQ

x 10 F N /QK

5
0.5

-2

0

10

20

-4

-4

4

0
0

10

0

20

-4

x 10 H premium

1.5

x 10 F premium

1

0

10

x 10

-3

20

HQ

-5
5

1

0

0.5

-1

-5

0

-2

-10

0

10

x 10

20

0

2
0

0

10

20

0

-3

0

Loan F I to H FI
x 10

10

20

Loan H I to F FI

0

0

0.015

-0.5

10

20

Loan F FI to H E

0

0

0.01

-0.005

0.005

-0.01

10

-0.005
-1
-1.5

0

10

20

-0.01

0

10

20

0

0

10

20

-0.01520

Loan H FI to F E

CCC τ=0.1
CCC τ=00

1020

Figure 19: FIs’Net Worth Shock in H under Banking Globalization (2)

59

0

x 10

-4

H GDP

5

-2
-4
0

-0.5

0
-4
x 10

5

10
15
H Investment

-5

20

5

2

0
-5
x 10

5

0
-3
x 10

5

10
H N/QK

15

-5

20

0
-4
x 10

5

10
F N/QK

15

20

2

10
15
F Investment

20

0

5

10

15

20

0
0
-4
x 10

5

10
e

15

-2

20

CCC τ=0.1
BGG τ=0.1

0
-2

F GDP

0

-1
-1.5

-5

0

-2
-4

x 10

CCC τ=0
0

5

10

15

20

Figure 20: Entrepreneurial Net Worth Shock in H under Banking
Globalization (1)

-4

2

F

-5

x 10 H N /QK

5

F

-3

x 10 F N /QK

-0.8

E

x 10 H N /QK

1

0

0

-1

0

-2

-5

-1.2

-1

-4

0

10

20

-10

-4

1

0

10

20

-1.4

-5

x 10 H premium4x 10 F premium

5

2

0

0

-5

0
x 10

10
-4

20

HQ

2

0.5
0

E

-4

FQ

0
x 10

10

20

0

0

10

20

-2

-4

6

-2

-5

x 10 F N /QK

0

10

20

-10

-3

Loan F I to H FI
x 10

2

4

0

2

-2

0

-4

0

10

20

-2

-3

Loan H I to F FI
x 10

4

0

10

0

Loan H FI to F E
x 10

-1

CCC τ=0.1

2

0

10

20

-2
0

10

20

0

0

10

20

-3

Loan F FI to H E
x 10

20

-3

CCC τ=00

1020

Figure 21: Entrepreneurial Net Worth Shock in H under Banking Globalization(2)

60

GDP correlation

Technology shock
1

1

1

0.8

0.8

0.8

0.6

0.6

0.6

0.4

0.4

0.4

0.2

0.2

0.2

0

0

0

-0.2

-0.2

-0.2

0

0.2

0.4

0

γ

0.2

0.4

0

F

0.2

0.4
E

τ

τ

GDP correlation

Monetary policy shock
1

1

1

0.8

0.8

0.8

0.6

0.6

0.6

0.4

0.4

0.4

0.2

0.2

0.2

0

0

0

-0.2

-0.2

-0.2

0

0.2

0.4

0

γ

0.2

0.4

CCC
BGG

0

F

0.2

0.4
E

τ

τ

Figure 22: GDP Bilateral Correlations with Varying
Openness Parameters (1)GDP correlation

FIs net worth shock
1

1

1

0.8

0.8

0.8

0.6

0.6

0.6

0.4

0.4

0.4

0.2

0.2

0.2

0

0

0

-0.2

-0.2

-0.2

0

0.2

0.4

0

γ

0.2

0.4

0

F

0.2

0.4
E

τ

τ

GDP correlation

Entreprenurial net worth shock
1

1

1

0.8

0.8

0.8

0.6

0.6

0.6

0.4

0.4

0.4

0.2

0.2

0.2

0

0

0

-0.2

-0.2

-0.2

0

0.2

0.4
γ

0

0.2

0.4
F

τ

CCC
BGG

0

0.2

0.4
E

τ

Figure 23: GDP Bilateral Correlations with Varying
Openness Parameters (2)61