International diffusion of shocks under different degrees of cross-country shocks comovement and economic integration

This paper studies the international transmission of shocks under different degrees of cross-country shocks comovement and economic integration via a two country-two good model with recursive preferences, frictionless markets, and correlated short- and long-run innovations. In contrast to recent studies, I show that the inclusion of cross-country balance sheet linkages and borrowing constraints does not represent a necessary condition to produce a strong international propagation mechanism. The novel risk sharing mechanism embodied in the model produces symmetric and synchronized movements in consumption and stock prices even if there are uncorrelated shocks and segmented goods markets. Nevertheless, model's results give rise to a "quantitative trade-off". On the one side, the presence of correlated long-run growth prospect is needed to produce a relatively low risk-free rate and a relatively high equity risk premium (consistent with asset pricing data), a no-close to unity cross-country consumption growth correlation (consistent with international consumption data), and the Backus-Smith correlation. On the other side, a negative short-run shock is key to produce a large and synchronized drop in real and financial flows (consistently with the properties of the 2008-2009 global demand collapse).