Business Cycles and the Asset Structure of Foreign Trade

International financial markets are widely believed to be important for the international transmission of business cycles, since they determine the extent to which individuals can smooth consumption in the presence of country-specific shocks to income. Using a two-country equilibrium model with restricted asset trade, we find that the absence of complete financial integration may not be important if shocks to national economies have low persistence or are transmitted rapidly across countries. However, if shocks are highly persistent or are not transmitted internationally, the extent of financial integration is central to the international transmission of business cycles.