The International Finance Multiplier in Business Cycle Fluctuations

In the wake of the gGreat Recessionh of 2007-09, recent studies have emphasized the importance of the ginternational finance multiplier (IFM)h mechanism for inter- national business cycles, using calibrated two-country models. This paper develops and estimates a two- country model with the IFM mechanism using 21 time series from the Euro Area (EA) and the US. The estimation results show that during the past quarter-century, EA shocks to the external finance premium and net worth not only had a considerable effect on the EA economy together with an EA neutral technology shock, but also were transmitted to the US through the IFM mechanism and had a great impact on the US economy together with a US marginal efficiency of investment (MEI) shock. The rate of EA neutral technological change and the US MEI shock then have strong correlations with lending attitudes of banks in the EA and the US, and thus the EA neutral technology shock and the US MEI shock are likely to represent disturbances to the banking sectors in the EA and the US. These findings therefore demonstrate that financial factors are important sources of EA and US business cycle fluctuations over the past quarter-century.