The Transmission Mechanisms of International Business Cycles: Output Spillovers through Trade and Financial Linkages 
International trade and financial linkages may be an important channel through which economic shocks propagate across countries. For example, a contractionary U.S. monetary policy shock may reduce U.S. demand for foreign goods through the income effect, with a negative impact on foreign economies. Moreover, U.S. banks may reduce the supply of credit to foreign borrowers. The strength of these effects likely depends on the size and the patterns of international trade and financial linkages. In addition, a chain of indirect effects could further amplify these direct spillovers. Despite the salience of such spillovers and the greatly increased economic effects of globalization in the last few decades, the literature provides only fragmented answers to many important questions: How large are international spillovers relative to domestic effects? Through which international linkages do shocks propagate across countries? Are the indirect effects of output spillovers quantitatively important?
This paper sheds new light on these questions by studying how domestic aggregate shocks transmit across borders through the networks formed by bilateral trade and financial linkages, thereby engendering cross-country comovement in real economic activity. The authors focus on U.S. monetary shocks, since they are often perceived as an important driver of international business cycles due to the size of the U.S. economy and the dollar’s role as a dominant currency.
Key Findings
- U.S. monetary tightening reduces foreign output, with larger effects in countries that are relatively more open to international trade.
- U.S. monetary shocks generate significant indirect effects that propagate through the network of bilateral trade linkages
- Financial openness, measured in a variety of ways, does not appear to be as important as trade openness in explaining cross-country heterogeneity in output responses, and the associated indirect effects are small. Overall, trade linkages are more relevant than financial linkages in explaining international spillover effects of monetary shocks on real economic variables.
Implications
Based on their findings, the authors conclude that the models that do not account for direct and indirect linkages between countries are likely incomplete. They believe that empirical and theoretical studies of international business cycles should incorporate measures of endogenous amplification through network effects. Abstracting from these indirect spillovers, they conjecture, may result in mismeasurement of the effects and yield theoretical predictions that are both quantitatively and qualitatively different from what they otherwise would be.
Abstract
We study the transmission channels through which shocks affect the global economy and the cross-country comovement of real economic activity. For this purpose, we collect detailed data on international trade and financial linkages as well as domestic macro and financial variables for a large set of countries. We document significant international output comovement following U.S. monetary shocks, and find that openness to international trade matters more than financial openness in explaining cross-country spillovers. In particular, output in countries with a high share of exports and imports responds to U.S. monetary shocks significantly more than output in countries with a low share, whereas we do not find material heterogeneity depending on international investment positions or financial flows in the balance of payments. We further document strong network amplification associated with the patterns of bilateral trade flows, as indirect spillovers account for nearly half of the total effect. Studies that do not account for direct bilateral linkages between national economies – and the indirect linkages through the network they form — may thus present an incomplete view of international business cycles.