International transmission of financial shocks in an estimated DSGE model

• We estimate a two-region open economy DSGE model with financial frictions.
• The baseline model cannot replicate the high cross-regional correlation in the data.
• We find more realistic results with ad hoc, cross-regional financial shock correlation.
• We generate an endogenous cross-regional correlation by including global banks.

This paper investigates the transmission of financial shocks across large economies. To quantify these effects, we estimate a two-region open economy DSGE model that includes frictions in credit markets. The baseline model fails to replicate the high correlation between the U.S. and Euro Area macroeconomic variables. Allowing for an ad hoc, cross-regional correlation in financial shocks considerably improves the model's ability to match the data. We extend the baseline model by including global banks, and generate an endogenous cross-regional correlation of borrowing costs. Simulations demonstrate large spillover effects, and highlight the importance of including frictions in international financial contracts for more accurately capturing the high cross-regional correlation.