DP11468 Market Integration and Global Crashes

Author(s): Semyon Malamud, Aytek Malkhozov
Publication Date: August 2016
Keyword(s): Crashes, Crises, Financial Frictions, market integration
JEL(s): F36, F62, F65, G01, G12
Programme Areas: Financial Economics, International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11468

We develop an equilibrium model of real and financial market integration in which real firms and financial actors independently decide on their investment into different locations (countries). We show that, in the presence of financial frictions, firms' real investment choices may become strategic complements, leading to multiple, self-fulfilling equilibria, as well as to real fragility, whereby a small change in one country's fundamentals triggers a large large change in real investment everywhere. This fragility may lead to a global crash in which severe underinvestment into countries with under-developed financial markets spills over all other countries. We show that such global crashes are particularly severe when frictions are sufficiently symmetric across countries. By contrast, with enough asymmetry, the economy is likely to end up in a local crash equilibrium in which countries with low real investment barriers suffer the most.