Starting with the seminal contributions of Bernanke and Gertler (1989) and Kiyotaki and Moore (1997), a large theoretical literature in macroeconomics has studied the implications of credit market imperfections for investment and output dynamics. At the heart of this literature is the inverse relationship between firms’ financial assets, or equivalently internal funds, and the agency costs of investment. When asymmetric information or moral hazard problems entail agency costs in lending relationships, firms’ debt capacity is constrained by the level of assets that can be pledged to outside lenders.
An adverse shock that worsen financial conditions may therefore generate a negative spiral, where low profits reduce debt capacity and hence investment, which further reduces profit, amplifying the initial negative shock, and so forth. This amplification mechanism, known as the credit multiplier or the financial accelerator, has been extremely influential in explaining how relatively small and temporary exogenous shocks to the economy may be amplified and become persistent.
The past two decades have witnessed profound changes in financial markets, and equity markets in particular, in form of greater international financial integration as documented, among others, by Lane and Milesi&Ferretti (2006). Naturally, financial market integration needs market liberalization in order to be accomplished in terms of assets substitutability conditions and perfect mobility. The mobility is perfect in the absence of capital and transactions control, institutional barriers and transaction cost. In this paper we focus on equity markets and model financial liberalization, and the consequent market integration, through a fall in portfolio holding costs. The latter can be associated with the drop in fixed banking commissions and the effects of mergers among stock exchanges observed in advanced countries during the last 20 years.
We maintain that understanding how financial integration alters the transmission of monetary policy shocks is a relevant avenue of research for both policy makers and scholars to the extent i) an increasing number of countries lift the strains of regulation on stock exchanges across the world and ii) changing transmission channels of monetary policy have important implications for the inflation&output trade&off and for the appropriate monetary policy response to asset prices, if any. We devote particular attention to stock prices because they play an important role in the transmission of monetary policy to the real economy, but the investigation of the consequences of financial integration on the monetary transmission channels is still scant in the literature.
In a common currency area (CCA) national governments delegate »
