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Productive Misallocation and International Transmission of Credit Shocks

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Last updated: February 2023

We develop an asymmetric, two-country equilibrium business cycle model to study the role of international trade in transmitting the real effects of financial shocks across borders. Our heterogeneous firms have differing needs for external finance and face occasionally binding collateral constraints that hinder their investments, while input-output linkages facilitate trade in both final goods and intermediate inputs. When confronted with global financial shocks, our model predicts that a recession in a large economy calibrated to the U.S. considerably alters a recession in its smaller trade partner calibrated to Canada, with distinct investment dynamics driving the transmission. The reverse does not hold.