Financial Frictions, the Great Trade Collapse and International Trade over the Business Cycle

Abstract

This paper investigates the impact of financial frictions on the dynamics of international trade over the business cycle and their role in the great trade collapse of 2008–2009. The study introduces cash flow constraints into an open-economy general equilibrium model with heterogeneous firms in which international trade is more dependent on external finance than domestic sales. The analysis demonstrates that endogenously driven countercyclical changes in the external finance premium amplify the effects of real and financial shocks on trade and help to explain the high trade income elasticity observed in the data. The paper shows that trade finance significantly contributed to the decline in trade during the global financial crisis. The model developed is also able to account for the sharp deterioration in the labour wedge and for the changes in the relative prices of domestic and exported goods during the crisis.