Financial spillover and global risk in a multi-region model of the world economy

Abstract

This paper estimates a three-region DSGE model (EA, US, RoW) with international financial linkages in the form of cross-border equity holding and allowing for region-specific as well as global financial shocks, which match empirical measures of financial tightness and global stock market valuation. Spillover from financial shocks increases with international financial integration and is practically zero under full home bias in normal times. The global risk captures international synchronisation of financial cycles. Spillover of financial shocks is amplified at the zero lower bound, at which investment risk takes on the characteristics of a general uncertainty shock. The model results suggest that integrated financial markets should provide a powerful motivation for international policy coordination to prevent financial turmoil.