A Neoclassical Model of World Financial Cycles

Emerging markets face large and persistent fluctuations in the sovereign spreads on the dollar debt they issue in international markets. How much of these fluctuations are driven by local shocks and how much are driven by financial conditions in developed economies? We develop a neoclassical business cycle model of a world economy with a single developed country, the North, and many emerging markets economies, the South. Our model integrates standard asset pricing features and explicitly models the endogenous default decisions of both northern firms and southern countries. In it, Northern households invest in domestic stocks and two types of defaultable debt—domestic corporate debt and international sovereign debt. The model accounts well for fluctuations in asset prices in both the North and the South. We use the model to identify the drivers of Southern spreads during the 1994-2023 period. We find that in the 2008-2016 period, termed the global cycle phase, the North accounts for 68% of the fluctuations in average Southern spreads. Over the whole period, however, Northern shocks account for less than 20% of these fluctuations.