The impact of uncertainty on the macro-financial linkage with international financial exposure

Abstract

This paper investigates the international transmission of various sources of uncertainty between the financial sector and the real economy. I focus on calibrating a two-country DGSE model with an international financial exposure in the banking sector for the Euro Area (EA) and the United States (US). In particular, the model studies the transmission mechanism of macroeconomic, monetary policy, financial and stock market volatility uncertainty. The model assumes that uncertainty originates in the foreign economy (US), and studies the spillover effect to the domestic economy (EA). The international transmission mechanism is driven by the international financial exposures, where domestic banks hold foreign banks’ assets as a second market activity. The analysis suggests that the spillover effects from foreign uncertainty have in many cases a sizeable and persistent impact on output, lending and asset prices. In particular, I find that macroeconomic and monetary policy uncertainty drive a global business cycle, where uncertainty leads to a drop in home and foreign GDP.Finally, the paper investigates the effectiveness of macroprudential policy when there is higher uncertainty about the policy rate in a foreign economy. Results show that both domestic and cooperative regulations, where both countries implement caps to the loan-to-value ratio, are enable to reduce the negative impact on GDP that such a shock produces.