Financial Frictions and the International Transmission of Shocks

This study presents a two-good, two-country model with financial frictions, where banks facing a borrowing constraint intermediate funds between households and firms. The endogenous fluctuations of international relative prices increase the business cycle co-movement across countries when combined with habit formation in consumption and investment adjustment costs. Financial frictions due to the borrowing constraint of the banks further amplify the effects of productivity and capital quality shocks within a country and across the two countries.