Financial Markets and Financial Leverage in a Two-country World Economy

tional transmission mechanism in the context of a two-country general equilibrium model. I incorporate realistic frictions with respect to the external financing of investment, and I calibrate these frictions to reflect important differences in lending institutions between developed and developing economies. To overcome these frictions, the paper focuses, in particular, on the role of leverage in transmitting shocks from developed economies to developing economies. The results imply that high-leverage economies are particularly vulnerable to external shocks, and that asymmetries between lending conditions across economies provide a strong source of transmission for shocks from developed to developing economies. Furthermore, slowdowns in economic activity are severely amplified by financial frictions. The model implies that the degree of amplification is directly related to the degree of leverage in the economy. In many developing economies, firms face significant capital market imperfections when raising external funds to finance new investment projects. These frictions stem from underlying asymmetries of information between borrowers and lenders. To overcoming these frictions, lenders must either engage in costly monitoring activities or require significant levels of collateral when financing investment projects. In such an environment, fluctuations in world demand lead to fluctuations in asset values that influence the overall level of selffinancing. A contraction in demand causes asset values and hence net worth to fall relative to financing needs. As a result, borrower